Chapter 31 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. Foreign exchange markets are also environments where arbitrage across assets is salient. Indeed, purchasing power parity, uncovered interest parity, and covered interest parity are all descriptions of arbitrage across currencies, goods, and interest-bearing assets. Thus a simple theory of cross-asset arbitrage predicts the bluered exchange rate well, while the dollar price of each asset is quite different from its fundamental. Triangular arbitrage, a fundamental aspect of exchange rate theory, holds in these data, while a simple notion of inter-temporal arbitrage is soundly refuted.