The Experimental Study of Asset Pricing Theory

Abstract

This monograph sets the stage for experiments by first examining a sample data set that looks very much like the typical historical data one gathers from the field, only it was actually generated in the laboratory so that we know what really went on. The example demonstrates how misleading the traditional analysis can be. It then moves on to discuss risk aversion, since asset pricing theory builds on risk aversion. The issue is — is there enough risk aversion in the laboratory given typical levels of compensation? Asset pricing theory also builds on competitive markets and competitive equilibrium, but these are actually purely abstract notions, without any suggestion of how to generate them in practice. The article builds on the path-breaking experimental work of Vernon Smith and Charles Plott who demonstrated that certain trading institutions indeed allow us to bring about competitive markets and competitive equilibrium. The author presents the main findings — first concerning simple static asset pricing models, moving on to dynamic pricing theory, and the implications of ambiguity aversion. Asset pricing theory rarely discusses how markets reach equilibrium, but experiments shed new light on price behavior during equilibration, as well as on off-equilibrium allocation dynamics. This monograph also examines information aggregation and competitive markets for loan and insurance contracts, where adverse selection may preclude equilibration, and even when not, the resulting allocations may be Pareto sub-optimal.