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Published November 30, 2017 | Submitted
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Price Discovery in Financial Markets: The Case of the CAPM

Abstract

We report on experiments of simple, repeated asset markets in two risky securities and one risk-free security, set up to test the Capital Asset Pricing Model (CAPM), which embeds the two most essential principles of modern asset pricing theory, namely, (i) financial markets equilibrate, (ii) in equilibrium, risk premia are solely determined by covariance with aggregate risk. Slow, but steady convergence towards the CAPM is discovered. The convergence process, however, halts before reaching the actual equilibrium. There is ample evidence that subjects gradually move up in mean-variance space, in accordance with the CAPM. Yet, adjustment stops as if the remaining trading time was insufficient to complete all the transactions that are needed to guarantee improvements in positions. We conjecture that this is due to subjects' hesitance in the face of market thinness. Because the convergence process halts, statistical tests reject the CAPM.

Additional Information

Bossaerts thanks the Yale School of Management for their hospitality during the period when this draft was written. Preliminary versions of this paper circulated under the title "Experimental Tests Of The CAPM As A Model Of Equilibrium In Financial Markets." The many comments during a seminar at the Yale School of Management, at the Conference on Microstructure and High Frequency Data in Paris (December 1998) and at the Conference on Price Discovery organized by the SFS in Toulouse (March 1999) are gratefully acknowledged. Steve Ross reminded the authors of the opportunities created by the completeness of the markets in the experiments. The financial support of the National Science Foundation and the California Institute of Technology Laboratory for Experimental Research in Economics and Political Science is gratefully acknowledged. Published as Bossaerts, Peter and Kleiman, Daniel and Plott, Charles (1999) Price Discovery in Financial markets: the case of the CAPM. In: Information, finance, and general equilibrium. Collected papers on the experimental foundations of economics and political science. No.3. Edward Elgar, Cheltenham, UK, pp. 445-492.

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