Experiments with Arbitrage Across Assets

Theoretical finance is essentially the study of inter-temporal arbitrage, but it is often interesting also to analyze relationships between asset prices. Cross-sectional analysis makes it possible to purge both field and laboratory data of unobservable changes in time-varying fundamentals. Also, although backward induction is at the heart of asset-pricing theory, subjects may find its logic dauntingly complex. They may be able to perceive cross-asset arbitrage opportunities much more readily. Caginalp and Constantine (1995) study two closed-end funds traded on the New York Stock Exchange, consisting of essentially identical portfolios under the same manager. They show that the relevant relative price is statistically significantly different from unity. Using a simple model of market momentum calibrated from their field data, they explain bubbles in experimental asset markets reported in Porter and Smith (1989). O'Brien and Srivastava (1991) use treatments with complex informational where several assets were traded. They found that markets did not aggregate information efficiently, but it is not always possible to detect these inefficiencies using standard statistical tests. In some treatments, two assets' dividends were perfectly negatively correlated, and a simple pricing relationship that was confirmed in the data. Another more subtle con­ nection between two asset prices received some but not overwhelming support in these experiments. Foreign exchange markets are also environments where arbitrage across assets is salient. Indeed, purchasing power parity, uncovered interest parity, and covered inter­ est parity are all descriptions of arbitrage across currencies, goods, and interest-bearing assets. Since field data on international transactions are among the oldest economic sta­ tistics and since scholars as illustrious as Ibn Khaldoun (1375) and David Hume (1752) have written on exchange rates, it is somewhat surprising that the first foreign exchange market experiments were conducted only in this decade. Fisher and Kelly (2000) explored foreign exchange markets in the laboratory by running sessions based upon the classic treatment of Smith, Suchanek, and Williams (1988). Fisher and Kelly's treatments capture two important aspects of field foreign exchange markets. First, subjects trade blue and red assets for dollars, just as foreign exchange traders use a key currency for most international transactions. Second, there are no goods markets; indeed, only a negligible fraction of foreign exchange transac­ tions in the field is used for imports. The main finding of these experiments is that both the blue and red assets experience significant bubbles, but they are highly correlated.