Game Theory and Financial Market Regulation

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Game Theory and Financial Market Regulation
-- Chen Sun This paper examines the rationale for regulation of financial market by using game theory models. The paper first introduces Game Theory, examines the necessity of normal market regulation by using Game Theory, and finally applies Game theory models to Financial information market and concludes that, to achieve a healthy financial market, regulation is necessary to 1) increase cost of financial information manipulation and 2) bring back the confidence of investors.

10/1/2010

Game Theory and Financial Market Regulation

Table of Contents
Introduction to game theory ....................................................................................................... 2 What is Game Theory?............................................................................................................. 2 How to Apply Game Theory? ................................................................................................ 2 Game Theory and Market Regulation ....................................................................................... 5 Regulation for Prisoner’s Dilemma........................................................................................ 5 Game Theory Model in a Simplified Sample Market .......................................................... 6 Season 1: The Lettuce Market at the Beginning...................................................................... 7 Season 2: Bad Bobby’s Wicked Idea ......................................................................................... 7 Season 3: Good Bobby’s Dilemma ........................................................................................... 8 Season 4: Scientist’s Discovery ............................................................................................... 9 Season 5: Government’s Regulation ....................................................................................... 9 Roles of the Government ....................................................................................................... 10 Application of Game Theory to Financial Market ................................................................. 11 Stage 1: Management Tend to Fake earnings ..................................................................... 11 Stage 2: Occurrence of Scandals ........................................................................................... 12 Stage 3: Government Regulation .......................................................................................... 12 The Role of Regulation........................................................................................................... 14 Relevant Other Theoretic Perspectives .................................................................................... 15 Market Failure and Efficiency............................................................................................... 15 Externalities ............................................................................................................................. 15 Signaling .................................................................................................................................. 17 Appendix A ................................................................................................................................. 18 Appendix B .................................................................................................................................. 19 Appendix C ................................................................................................................................. 20

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Game Theory and Financial Market Regulation

Introduction to game theory
What is Game Theory? Simply speaking, game theory is the theory that studies how groups of people interact, (Levine) and particularly focuses on the situations, games, where the outcomes depend not only on...
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