Contagion and Return Predictability in Asset Markets: An Experiment With Two Lucas Trees

Abstract

Using a laboratory experiment, we investigate whether contagion can emerge between two risky assets, even when their fundamentals are not correlated. To guide our experimental design, we use the ‘Two trees’ asset pricing model developed by Cochrane et al. (2007). The model makes time-series and cross-section return predictions following a shock to one of the two assets’ dividend distributions. As the model predicts, we observe (1) positive auto correlations in the shocked asset, (2) a positive contemporaneous correlation between the two assets, and (3) time-series and cross-sectional return predictability from the dividend price ratio. In line with the rational foundation of the model, the model’s predictions have stronger support in markets with relatively sophisticated agents.

Keywords: contagion; asset pricing; two trees model; experimental pricing; time series momentum; return predictability

JEL Classification: C53; C92; D50; G12