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Convex incentives in financial markets: an agent-based analysis

Annalisa Fabretti (), Tommy Gärling (), Stefano Herzel () and Martin Holmen
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Tommy Gärling: University of Gothenburg
Stefano Herzel: University of Rome

Decisions in Economics and Finance, 2017, vol. 40, issue 1, No 20, 375-395

Abstract: Abstract 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.

Keywords: Incentives; Market instability; Agent-based simulations (search for similar items in EconPapers)
JEL-codes: D86 D53 C63 (search for similar items in EconPapers)
Date: 2017
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Working Paper: Convex Incentives in Financial Markets: an Agent-Based Analysis (2015) Downloads
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DOI: 10.1007/s10203-017-0200-1

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