Understanding misunderstanding in experimental asset markets

Trader misunderstanding is believed to contribute to mispricing in experimental asset markets. However, it remains unclear to what degree mispricing is driven by traders’ own misunderstanding (‘first-order misunderstanding’) and/or their attempts to capitalize on beliefs of others’ misunderstanding (‘higher-order misunderstanding’). In a laboratory market setting, we pair a standard double auction market design using a declining-value asset accompanied with questions prompting traders for forecasts of both future intrinsic cash flows and future bid and ask values. We observe that traders frequently forecast different values for future intrinsic cash flows than for future bids and asks. Many traders who provide accurate intrinsic cash flow forecasts nevertheless purchase assets above their forecasts. When doing so, these traders generally express expectations of future bids that exceed forecasted intrinsic cash flows. We also observe that both trader’s first-order misunderstanding of asset fundamentals and higher-order beliefs of other traders’ misunderstanding are separately related to mispricing.