An experimental investigation of asset pricing in segmented markets.

• Author: Ackert, Lucy F.

1. Introduction

   In some markets, the trading of securities is restricted across investors. In this article we examine the effect of an investment barrier on asset pricing and portfolio composition using an experimental method. Whether the international capital market is integrated has received significant attention from researchers, yet as Solnick (1977) aptly points out, tests of integration and segmentation can be problematic. We specify a particular type of market imperfection and examine the resulting impact on market and investor behavior following Solnick's suggestion, as do Errunza and Losq (1985).

   Many experimental economics studies have examined trading behavior and pricing in laboratory asset markets, including Plott and Sunder (1988) and Forsythe and Lundholm (1990). Typically the research investigates whether asset prices converge to theoretical predictions and efficiently reflect information. There are few experimental examinations of multi-market trading, particularly with cross-market trading restrictions. (1) Barriers to trade are not uncommon, particularly in emerging capital markets. (2)

   Recently Qi and Ochs (2009) provide experimental evidence that prices in a market reflect information in another market, even if the markets are legally separated. In Qi and Ochs, the two markets are fully segmented in that traders can trade only in their own market, whereas our asset markets are only partially segmented. (3) Another key design difference between our markets and those of Qi and Ochs is that the assets traded in each of their markets represented identical claims to the underlying flow of dividends. In contrast, the assets traded in our experimental markets represent different claims with distinct dividend payoffs.

   In our experiment, some traders are able to transact in the markets for two assets, whereas others can trade in only one market. Errunza and Losq (1985) refer to this structure as mild segmentation and provide theoretical predictions regarding pricing outcomes, including a "super" risk premium for assets with trading restrictions. Because some investors are prevented from holding the global market portfolio, the ineligible stock trades at a discount so that a risk premium is earned on this stock. If the stocks were traded freely, their prices would rise as expected return falls. Consistent with Errunza and Losq's predictions, the evidence indicates that easing of trading restrictions lowers a firm's cost of capital (Errunza and Miller 2000; Karolyi 2006).

   The purpose of this article is to further examine how risk and the ability to diversify affect pricing and portfolio holdings across legally segmented markets. With our experimental design we are able to investigate predictions for market outcomes and trader decision making, while controlling for possible confounding influences. (4) This research provides new insight into the outcomes of legal restrictions on trading and investor behavior, an examination that cannot be conducted in naturally occurring markets. With an experimental method, we are able to control information and extraneous influences, while focusing on the questions of interest. (5)

   The results indicate that legal restrictions can have very significant effects on asset pricing. In our experimental markets, the price of the asset that cannot be traded freely is lower than the price of the asset traded by all. Our markets provide additional insight into traders' decisions. The assets are designed so that unrestricted traders have the opportunity to perfectly hedge risk. Errunza and Losq show that as the correlation between the two assets falls, the effect of segmentation on pricing increases. Our assets are perfectly negatively correlated, and, thus, our design provides a strong incentive for risk-averse traders to balance their holdings--if they can. Although a minority of unrestricted traders takes advantage of this opportunity, most do not. The remainder of the article is organized as follows. Section 2 describes the experimental design. Section 3 motivates and defines the hypotheses to be tested. The section following presents the experimental results. Section 5 concludes.

2. Experimental Method

   The asset market experiments were conducted in the EXperimental Economics CENter (EXCEN) at the Andrew Young School of Policy Studies at Georgia State University. We report on 11 market sessions in two treatments. (6) The experimental design, summarized in panel A of Table 1, includes markets with two traded assets. Treatments A and B differ only in terms of traders' initial endowments. The two endowment structures allow us to assess whether more or less symmetric buying and selling pressure impact pricing or asset holdings. The two endowment structures are necessary to isolate the effect of partially segmented markets and ensure that observations are not the result of asymmetric buying pressure. Asset 1 is eligible for trade by all nine participants, and asset 2 is not available, or ineligible, for three of the nine participants. (7) Traders 1-3 can trade only asset 1, and traders 4-9 can trade both assets.

   Nine traders participated in each session. All trading was in francs, the experimental currency, which was converted into dollars at a rate of 1 franc = $0.0012 so that 1000 francs = $1.20. Subjects were undergraduate and graduate students with a variety of majors. All were inexperienced in that none had participated in an earlier session of similar design. Students earned from $16.25 to $64.50 for their participation, with an average payout of $41.13. (8)

   Each market session consisted of 15 three-minute periods, organized as computerized double auction markets using the z-Tree (Zurich Toolbox for Readymade Economic Experiments) software (Fischbacher 2007). (9) With z-Tree subjects can transact in real time over a number of market periods. They can post bids and asks and also act as price takers. For all sessions, traders were permitted to transact each asset one unit at a time. Although participants may have been restricted from trading in one of the markets, they could observe trading activity in both markets on their computer screens.

   On arrival subjects received a set of instructions, and one of the experimenters did an extensive recap while addressing all procedural and technical questions. (10) The sessions generally required 2 1/2 hours to complete. At the beginning of each trading period, participants were endowed with shares of the securities and cash, though some asset endowments were set to zero, as Panel A of Table 1 indicates. Subjects were endowed with cash at the beginning of each period to finance trade, and the amount of cash was chosen so that all participants had portfolios of equal expected value. At period end, each asset paid a dividend that was randomly determined using the distributions reported in panel B of Table 1, with dividend draws being intertemporally independent. Note that the expected dividend for both assets is identical at 150 francs per period. At the end of a period, the observed state of nature was publicly announced, and asset holders received their dividends. The experimenter also reported the average transaction prices of each asset at the end of each trading period. Each asset had a one period life. Subsequent trading periods began anew with constant endowments for each trader across all 15 trading periods.

   At the end of each period the final cash balance was (privately) displayed on a subject's computer screen. After the 15 trading periods were finished, participants completed a post-experiment questionnaire that included demographic questions as well as reactions to the experiment. To motivate them to respond carefully, they were given additional compensation of $4 for completing the questionnaire. Thereupon the experimenters paid participants privately in cash.

3. Hypothesis Development

   As described in the previous section, our experimental design restricts some participants from trading in a stock. Figure 1 illustrates the design. The restricted investor can hold only the eligible security (asset 1), whereas the unrestricted investor can hold both the eligible and ineligible securities (assets 1 and 2). The two treatments differ only in regard to traders' initial endowments.

   [FIGURE 1 OMITTED]

   Errunza and Losq (1985) present a model of asset pricing in a mildly segmented world capital market. In their segmented markets, investors have unequal access to some markets. As in our design, the markets are not completely segmented because some traders can hold all securities (the unrestricted investors), and others can hold only eligible securities (the restricted investors). Errunza and Losq predict that in a world with mildly segmented capital markets and risk-averse investors, the ineligible assets will command a "super" risk premium. Because some investors are prevented from holding the ineligible assets, they cannot hold the global market portfolio, and a higher risk premium for ineligible stocks results. Without a super risk premium, the unrestricted investors would not hold the ineligible assets...