Prices And Allocations In Financial Markets: Theory and Evidence

The prices and allocations in two sets of asset markets experiments are studied. One set is the certainty equivalent of the other. In both sets, markets evidently price risk correctly (expected excess returns are proportional to covariance with aggregate risk) even when allocations are wrong (individual allocations do not reflect the portfolio separation predicted by theory). We explain this price-allocation paradox by adding perturbation terms to standard general equilibrium theory. Using data from the certainty-equivalent experiments, we show that the extent to which portfolio separation obtains is a poor measure of the efficiency of the final allocations. Instead, most of the utility losses stem from the wrong mix of riskfree versus risky securities. Price changes in both sets of experiments strongly correlate with a fully optimal aggregate excess demand. We also discover that allocational efficiency improves dramatically in the certainty equivalent experiments, yet find mixed evidence of this in the uncertainty experiments. Because utility losses all but disappear in the certainty equivalent experiments, the lack of allocational improvements in the uncertainty experiments cannot be attributed to poor incentives. We do find strong evidence, however, that subjects’ behavior reflect understanding of mean-variance efficiency: given the volatility of their portfolio, subjects manage to improve expected return when potential improvements emerge. This explains why we find that price changes are significantly related to a mean-variance optimal aggregate excess demand, and why pricing tends towards the predictions of the Capital Asset Pricing Model (CAPM).