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Convex incentives in financial markets: an agent-based analysis

Journal article
Authors Annalisa Fabretti
Tommy Gärling
Stefano Herzel
Martin Holmén
Published in Decisions in Economics and Finance
Volume 40
Issue 1-2
Pages 375-395
ISSN 1593-8883
Publication year 2017
Published at Department of Psychology
Centre for Finance
Department of Economics
Pages 375-395
Language en
Links doi.org/10.1007/s10203-017-0200-1
Keywords Agent-based simulations, Incentives, Market instability
Subject categories Economics

Abstract

© 2017, Springer-Verlag Italia S.r.l. We investigate whether convex incentive contracts are a source of instability of financial markets as indicated by the results of a continuous double-auction asset market experiment performed by Holmen et al. (J Econ Dyn Control 40:179–194, 2014). We develop a model to replicate the setting of the experiment and perform an agent-based simulation where agents have linear or convex incentives. Extending the simulation by varying features of actual asset markets that were not studied in the experiment, our main results show that increasing the number of convex incentive contracts increases prices and volatility and decreases market liquidity, measured both as bid–ask spreads and volumes. We also observe that the influence of risk aversion on traders’ decisions decreases when there are convex contracts and that increasing the differences in initial wealth among the traders has similar effects as increasing number of convex incentive contracts.

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