LSF professor Tibor Neugebauer provides empirical support for the Franco Modigliani and Merton Miller theorem in an upcoming edition of the Journal of Finance, some 60 years after the path-breaking principle was first published.
The so-called MM value-invariance theorem, a theoretical result on capital structure of corporate companies, was presented by Modigliani and Miller in 1958. It states that the market value of a firm is invariant to the firm’s leverage – different packaging of contractual claims on the firm’s assets does not impact the total market value of the firm’s debt and equity. The theorem suggests that the law of one price prevails for assets of the same “risk class.” The core of the theorem is an arbitrage proof, whereby if two assets, one leveraged and one unleveraged, represent claims on the identical cash flow, any market discrepancies that arise are arbitraged away. Due to its assumption of arbitrage-free, frictionless markets and perfect return correlations, no satisfactory test of the MM theorem could be provided on the basis of real-world market data in the past 60 years.
In their recent work titled « A Test of the Modigliani-Miller Invariance Theorem and Arbitrage in Experimental Asset Markets », to be published in the February issue 2019 of the Journal of Finance, Prof. Neugebauer and Gary Charness (UC Santa Barbara) were able to conduct an empirical test of the MM theorem in the laboratory. While they were able to find support for the theorem through the test, they make some concessions as regards to real world circumstances.
Perfect correlation necessary for empirical support
Charness and Neugebauer observed traders in an experimental asset market, in which they endowed subjects with cash, a leveraged and an unleveraged multi-period lived asset. The data gathered in the experimental study support the MM theorem for assets of identical risks when returns are perfectly correlated. The law of one price holds on average for unleveraged and leveraged cash flows of identical risk. When assets have the same expected (rather than identical) future returns the law of one price is violated, in contrast to the prediction of the capital asset pricing model.
The authors therefore claim that perfect correlation is necessary for the empirical support of the MM theorem. In contrast to the proof of the MM theorem, however, pricing is never arbitrage-free in the experiment. Discrepancies in asset prices never cease even with experienced traders during the experiment, though fewer arbitrage possibilities arise and discrepancies in pricing of assets occurs less frequently in markets where overall trader acuity is high.
Based on their experimental evidence, Charness and Neugebauer conclude that despite the support of the MM theorem, significant potential gains for arbitrageurs persist always. In the real world where exploiting price discrepancies requires that the arbitrageur takes risk, arbitrageurs, therefore, may require deep pockets and patience to lock in their arbitrage gains and the MM theorem may not be supported always.