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

69 Pages Posted: 1 Aug 2019

See all articles by Gary Charness

Gary Charness

University of California, Santa Barbara (UCSB) - Department of Economics

Tibor Neugebauer

Université du Luxembourg - Department of Finance

Date Written: January 19, 2018

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

Suggested Citation

Charness, Gary and Neugebauer, Tibor, A Test of the Modigliani-Miller Invariance Theorem and Arbitrage in Experimental Asset Markets (January 19, 2018). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3428299

Gary Charness

University of California, Santa Barbara (UCSB) - Department of Economics ( email )

2127 North Hall
Santa Barbara, CA 93106
United States
805-893-2412 (Phone)
805-893-8830 (Fax)

Tibor Neugebauer (Contact Author)

Université du Luxembourg - Department of Finance

Campus Kirchberg
6 rue Richard Coudenhove-Kalergi
L-1359 Luxembourg
Luxembourg

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