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Published February 2000 | Submitted
Working Paper Open

Basic Principles of Asset Pricing Theory: Evidence from Large-scale Experimental Financial Markets

  • 1. ROR icon California Institute of Technology

Abstract

We report on two sets of large-scale financial markets experiments that were designed to test the central proposition of modern asset pricing theory, namely, that risk premia are solely determined by covariance with aggregate risk. We analyze the pricing within the framework suggested by two theoretical models, namely, the (general) Arrow and Debreu's complete-markets model, and the (more specific) Sharpe-Lintner-Mossin Capital Asset Pricing Model (CAPM). Completeness of the asset payoff structure justifies the former; the small (albeit non-negligible) risks justifies the latter. We observe swift convergence towards price patterns predicted in the Arrow and Debreu and CAPM models. This observation is significant, because subjects always lack the information to deliberately set asset prices using either model. In the first set of experiments, however, equilibration is not always robust, with markets temporarily veering away. We conjecture that this reflects our failure to control subject' beliefs about the temporal independence of the payouts. Confirming this conjecture, the anomaly disappears in a second set of experiments, where states were drawn without replacement. We formally test whether CAPM and Arrow–Debreu equilibrium can be used to predict price movements in our experiments and confirm the hypothesis. When multiplying the subject payout tenfold (in real terms), to US $ 500 on average for a 3-h experiment, the results are unaltered, except for an increase in the recorded risk premia.

Acknowledgement

Financial support was provided by the Caltech Laboratory of Experimental Economics and Political Science, the National Science Foundation, the International Center For Finance at Yale University. We thank Bill Brown (Claremont), Peter DeMarzo (Berkeley), Will Goetzmann (Yale), Mark Johnson (Tulane), Tony Kwasnica (Penn State), Claude Montmarquette and Claudia Keser (CIRANO, Montréal), William Sharpe (Stanford), Woody Studenmund (Occidental College), and Ivo Welch (UCLA), for allowing us to involve their students in our experimental financial markets. The paper benefited from comments in a joint UCLA-Caltech workshop, at CEPR's 1999 Financial Markets Summer Symposium in Gerzensee, and during seminars at the Norwegian School of Management, the Claremont Graduate University, the University of Antwerp, and the University of Louvain

Additional Information

Published as Bossaerts, Peter and Plott, Charles (2004) Basic Principles of Asset Pricing Theory: Evidence from Large-scale Experimental Financial Markets. Review of Finance, 8 (2). pp. 135-169.

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Created:
August 19, 2023
Modified:
December 22, 2023