Efficient Derivative Pricing and Sequestered Capital: The Case of Investment Trust Pricing in 1929

Abstract

The efficient market hypothesis implies that the price of a financial derivative should mirror the value of its underlying asset(s). This model is used to reconsider an historic anomaly—the large, allegedly irrational, premia on investment trusts that preceded the 1929 crash. First, we reexamine evidence—highly cited for decades—alleging anomalous premia on portfolio-publishing trusts preceding the crash. Our assessment, based on current information-gathering capabilities, shows no evidence of anomalous premia in the cases considered. Secondly, we test our model on a data set of over 3,000 price observations, using regression discontinuity in time (RDiT) designs. As expected, the prices of blind trusts quickly corrected with the disclosure of their underlying portfolios. Our findings suggest that sequestered capital, rather than irrational exuberance, was primarily responsible for the premia on trusts in 1929.

Keywords: Efficient Market Hypothesis, Financial Derivative, Sequestered Capital, Closed-end Mutual Fund, Investment Trust, 1929 Stock Market Crash, Regression Discontinuity in Time Design (RDiT)

JEL Classification: G01, G12, G14