Contagion and Return Predictability in Asset Markets: An Experiment with Two Lucas Trees

Using a laboratory experiment, we investigate whether contagion can emerge between two risky assets, even when their fundamentals are not correlated. 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 two assets’ dividend distributions. As the model predicts, we observe (1) positive autorcorrelations in theshocked asset, (2) a positive contemporaneus correlation between the two assets, and (3) time-series and cross-sectional returnn predictability from the dividend price ratio. In line with the rational foundatin of the model, the model’s predictions have stronger suport in markets with relatively sophisticated agents.