Do Option-like Incentives Induce Overvaluation?\nEvidence from Experimental Asset Markets

Abstract

One potential reason for bubbles evolving prior to the financial crisis was excessive risk taking stemming from option-like incentive schemes in\nfinancial institutions. By running laboratory asset markets, we investigate the impact of option-like incentives on price formation and trading behavior.\nWe observe (i) that option-like incentives induce significantly higher market prices than linear incentives. We further find that (ii) option-like\nincentives provoke subjects to behave differently and to take more risk than subjects with linear incentives. We finally show that (iii) trading at\ninflated prices is rational for subjects with option-like incentives since it increases their expected payout.

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