Information aggregation, speculation, and arbitrage in a simple option market experiment

The fact that all arbitrage opportunities are exploited is a fundamental assumption of option pricing theory. Empirical and experimental studies of investment decisions, however, found that arbitrage is not completely exploited by individuals. Instead, observed behavior is much better explained by models of mental accounting (Thaler [1985]), in which different asset types are evaluated separately. An open question, however, is whether unexploited arbitrage opportunities will also be observed in market settings, in which traders learn from one another and prices can be influenced by a few arbitrage seeking traders. This paper reports an experimental study of option trading in a market framework and compares competing hypotheses : arbitrage-free option pricing (AFP), rational expectations equilibrium (REE), and several mental accounting hypotheses. All mental accounting hypotheses have a significantly better explanatory power than AFP and REE, but are not significantly distinguishable amongst each other. Finally, the aspects of typical individual trading behavior that may be responsible for the failure of the market to reach AFP are discussed.