Contagion and Return Predictability in Asset Markets: A Lab Experiment

Using a laboratory experiment, we investigate if contagion can emerge between two risky assets despite an absence of correlation among their fundamentals. To guide our experimental design, we use the ‘Two trees’ asset pricing model developed by Cochrane et al. (2007). The model makes time-series and cross-section return predictions following a shock to one of the assets’ dividend share. Consistent with the predictions of the model, we observe positive auto-correlation in the shocked asset, a positive contemporaneous correlation between the two risky assets, and time-series and cross-sectional return predictability using the dividend-price ratio. In line with the rational foundation of the model mechanics, the model’s predictions have higher support in markets with more sophisticated agents.