Basic Principles of Asset Pricing Theory: Evidence from Large-Scale Experimental Financial Markets

Caltech HSS Working Paper

48 Pages Posted: 3 Oct 2000

See all articles by Peter Bossaerts

Peter Bossaerts

University of Melbourne - Department of Finance

Charles R. Plott

California Institute of Technology - Division of the Humanities and Social Sciences

Date Written: January 2000

Abstract

We report on six large-scale financial markets experiments that were designed to test two of the most basic propositions of modern asset pricing theory, namely, that the interaction between risk averse agents in a competitive market leads to equilibration, and that, in equilibrium, risk premia are solely determined by covariance with aggregate risk. We designed the experiments within the framework suggested by two theoretical models, namely, Arrow and Debreu's complete-markets model, and the Sharpe-Lintner-Mossin Capital Asset Pricing Model (CAPM). This framework enabled us to measure how far our markets were from equilibrium at any point in time, thereby allowing us to gauge the success of the models. The distance measures do not require knowledge of the (uncontrollable) level and dispersion of risk aversion among subjects, and adjust for the impact of progressive trading on the eventual equilibrium. Unlike in our earlier, thin-markets experiments, we discovered swift convergence towards equilibrium prices of Arrow and Debreu's model or the CAPM. This discovery is significant, because subjects always lacked the information to deliberately set asset prices using either model. Sometimes, however, the equilibrium was not found to be robust, with markets readily veering away, apparently as a result of deviations of subjective beliefs from objective probabilities. Still, we find evidence that this did not destroy the tendency for markets to equilibrate as predicted by the theory. In each experiment, we formally test and reject the hypothesis that prices are a random walk, in favor of stochastic convergence towards CAPM and Arrow Debreu equilibrium.

JEL Classification: D51,G12,C92

Suggested Citation

Bossaerts, Peter L. and Plott, Charles R., Basic Principles of Asset Pricing Theory: Evidence from Large-Scale Experimental Financial Markets (January 2000). Caltech HSS Working Paper. Available at SSRN: https://ssrn.com/abstract=240649 or http://dx.doi.org/10.2139/ssrn.240649

Peter L. Bossaerts (Contact Author)

University of Melbourne - Department of Finance ( email )

Faculty of Economics and Commerce
Department of Finance
Carlton, Victoria 3010
Australia

HOME PAGE: http://bmmlab.org

Charles R. Plott

California Institute of Technology - Division of the Humanities and Social Sciences ( email )

1200 East California Blvd.
337 Baxter Hall
Pasadena, CA 91125
United States
626-395-4209 (Phone)

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