Contagion and Return Predictability in Asset Markets: An Experiment With Two Lucas Trees
55 Pages Posted: 6 Sep 2019 Last revised: 20 Nov 2019
Date Written: March 1, 2019
Using a laboratory experiment, we investigate whether contagion can emerge between two risky assets despite an absence of correlation in their fundamentals. To guide our experimental design, we use the ‘Two trees’ asset pricing model developed by Cochrane, Longstaff and Santa-Clara (2007). We draw on the model to make predictions regarding changes in the time-series and cross-section of returns in response to fundamental value shocks. We observe positive autocorrelation in the shocked asset, and a positive contemporaneous correlation between assets, as the model predicts. The dividend-price ratio forecasts the returns of risky assets, both in the time series and in the cross-section. There is more support for the model’s predictions in markets in which traders have greater cognitive ability.
Keywords: Contagion, Asset Pricing, Two Trees Model, Experimental Finance, Time Series Momentum, Return Predictability
JEL Classification: C53, C92, D50, G12
Suggested Citation: Suggested Citation