A Test of the Modigliani-Miller Invariance Theorem and Arbitrage in Experimental Asset Markets

Abstract

Modigliani and Miller (1958) show that a repackaging of asset return streams to equity and debt has no impact on the total market value of the firm if pricing is arbitrage-free. We test the empirical validity of this invariance theorem in experimental asset markets with simultaneous trading in two shares of perfectly-correlated returns. Our data support value invariance for assets of identical risks when returns are perfectly correlated. However, exploiting price discrepancies has risk when returns have the same expected value but are uncorrelated, and we find that the law of one price is violated in this case. Discrepancies shrink in consecutive markets, but seem to persist even with experienced traders. In markets where overall trader acuity is high, assets trade closer to parity.

Keywords: Modigliani-Miller theorem, asset market, twin shares, experiment, limits to arbitrage, perfect correlation, experience, cognitive reflection test, risk aversion

JEL Classification: C92, G12