Market Inefficiency

11 Key excerpts on "Market Inefficiency"

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  Investment Valuation

  Tools and Techniques for Determining the Value of any Asset, University Edition

  • Aswath Damodaran(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  The internal contradiction of claiming that there is no possibility of beating the market in an efficient market and requiring profit-maximizing investors to constantly seek out ways of beating the market and thus making it efficient has been explored by many. If markets were in fact efficient, investors would stop looking for inefficiencies, which would lead to markets becoming inefficient again. It makes sense to think about an efficient market as a self-correcting mechanism, where inefficiencies appear at regular intervals but disappear almost instantaneously as investors find them and trade on them.

  PROPOSITIONS ABOUT MARKET EFFICIENCY A reading of the conditions under which markets become efficient leads to general propositions about where investors are most likely to find inefficiencies in financial markets.

  Proposition 1: The probability of finding inefficiencies in an asset market decreases as the ease of trading on the asset increases. To the extent that investors have difficulty trading on an asset, either because open markets do not exist or because there are significant barriers to trading, inefficiencies in pricing can continue for long periods.

  This proposition can be used to shed light on the differences between different asset markets. For instance, it is far easier to trade on stocks than it is on real estate, since markets are much more open, prices are in smaller units (reducing the barriers to entry for new traders), and the asset itself does not vary from transaction to transaction (one share of IBM is identical to another share, whereas one piece of real estate can be very different from another piece that is a stone’s throw away). Based on these differences, there should be a greater likelihood of finding inefficiencies (both under- and overvaluation) in the real estate market.

  Proposition 2:

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  The Economics of Financial Markets

  • Roy E. Bailey(Author)
  • 2005(Publication Date)
  • Cambridge University Press

    (Publisher)

  Market efficiency is then interpreted as an absolute characteristic – an absolute that is never attained in practice. Very little is known about relative efficiency. Much more research is needed before any confident inferences can be made, both about whether the concept is itself interesting and, if so, about the outcome of comparisons made according to any given set of efficiency criteria. Summary Tests of efficiency cannot be separated from the models and the information sets on which their predictions are conditioned. Appearances can deceive; a test of efficiency is not model-free merely because the model is left implicit . This does not mean that tests of efficiency are impossible or worthless. It does mean that the conclusions about efficiency must be conditional on the model that provides the criteria for efficiency – the conclusions can never be incontrovertible. Hence, the bold question ‘are financial markets efficient?’ is, at best, a rhetorical device to initiate debate. Unequivocal answers deserve to be treated with the utmost suspicion. Predictability of prices and market efficiency 69 3.2.3 Beating the market Informational efficiency is often defined in terms of the profits that could be made by exploiting information: ‘A market is efficient with respect to a particular set of information if it is impossible to make abnormal profits (other than by chance) by using this set of information to formulate buying and selling decisions’ (Sharpe, Alexander and Bailey, 1999, p. 93). Similarly: ‘ efficiency with respect to an information set, , implies that it is impossible to make economic profits by trading on the basis of ’ ( New Palgrave Dictionary of Money and Finance , Newman, Milgate and Eatwell, 1992, Vol. I, p. 739; the symbol denotes the same set as the t used here). In the quotations, ‘abnormal profits’ and ‘economic profits’ (both can be under-stood to mean the same thing) must be determined according to some criterion or another.

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  Theory And Reality In Financial Economics: Essays Toward A New Political Finance

  Essays Toward a New Political Finance

  • George M Frankfurter(Author)
  • 2007(Publication Date)
  • World Scientific

    (Publisher)

  It also makes it sure that finance academics are not engaged in the process of discovery, the ultimate goal of science, because such process might bring an end to the ideology that rules the field. I call the search for the truth “discovery,” because this way I am avoiding the pitfalls of trying to define what truth is, or whether there is such a thing as truth at all. Searching for the truth, on the other hand, is like searching for the holy grail — we do not have to know even what it is, much less where to find it. There is also a hidden tale in the selection of the noun “efficiency” to describe the operation of the markets. In brief, it comes from the work of the 1990 Nobel Laureate in economics, Harry Markowitz (1952), who invented a mathematical and statistical method for selecting a stock port-folio. In that framework, all possible portfolio choices that should be selected by a risk-averse person, endowed with a quadratic utility of wealth function, are being said to be on the frontier of efficiency (also called second order stochastic dominance). Suffice it to say, however, that we despise inefficiency; thus, the opposite of inefficiency must be some-thing we value. Accordingly, there is a positive implied meaning to the term, whether or not we know its mechanics. In the context of Fama’s work, efficiency means that the market does best and, thus, one cannot do better than invest in the market as a whole. A situation like this is what economists call Pareto optimality. The sub-lime meaning of market efficiency is that markets for capital assets are Pareto optimal. 36 Theory and Reality in Financial Economics This notion, lately, found for itself several new euphemisms for the ben-efit of the common man, the most popular of which are “free markets,” 33 “globalization,” “new/space age,” “the new world order,” etc. Tinkering with markets, such as government regulations, means imposing inefficiencies — the bane of society.

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  The Large-Cap Portfolio

  Value Investing and the Hidden Opportunity in Big Company Stocks

  • Thomas Villalta(Author)
  • 2012(Publication Date)
  • Bloomberg Press

    (Publisher)

  Finally, as a practitioner, the ability to explain why a security or industry or sector or market is mispriced is paramount. Within the sea of market efficiency, why is this group or stock adrift? There must be a reason why we question market efficiency, and my guiding principle with regard to approaching stock research is to assume at the outset that the market has efficiently priced a stock. If a stock is mispriced, we must at the very least have a reason for believing that the market is in error. In the absence of even a crude understanding of why a company is undervalued (or overvalued), we lose the ability to differentiate between misunderstood situations and situations that may present opportunities.

  As research analysts attempting to identify exploitable market opportunities, it behooves us to understand the nature of market inefficiencies. While many of the anomalies I’ve described have no solid explanation, differentiating between inefficiencies that result spuriously and those that result from behavioral errors helps one to understand the broader view of market efficiency.

  Notes

  1. Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance 25(2), Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York. December 28–30, 1969 (May 1970): 383–417.

  2. Janus.com , “Rigorous Research,” https://ww3.janus.com/Janus/Retail/staticpage?jsp=jsp/GettingStarted/RigourousResearch.jsp .

  3. Americanfunds.com , “What Makes Us Different,” https://americanfunds.com/about/different/index.htm .

  4. Fidelity.com , “Why Fidelity Mutual Funds,” http://personal.fidelity.com/products/funds/mutual_funds_overview.shtml.cvsr .

  5. Rolf W. Banz, “The Relationship between Return and Market Value of Common Stocks,” Journal of Financial Economics 9 (1981): 16.

  6. Eugene F. Fama and Kenneth R. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance 47(2) (1992): 427–465.

  7. Jonathan B. Berk, “Does Size Really Matter?,” Financial Analysts Journal

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  The Handbook of Energy Trading

  • Stefano Fiorenzani, Samuele Ravelli, Enrico Edoli(Authors)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  The efficient market hypothesis has aroused interest in the public debate not because of its theoretical appeal, but mainly for its trading implications. In fact, if the disclosure of a certain information set to market participants does not affect their price forecast, no extra profits can be extracted on the basis of that information set. In the weak-form efficiency case the information set is basically the complete knowledge of price history. This implies that if a market is efficient in weak form, trading based on technical or statistical analysis cannot provide expected excess returns, while fundamental trading can still be profitable. In a semi-strong efficient market not even fundamental trading can be expected to overshoot the market, while the strong efficiency form is that theoretical situation in which not even with private information can we expect consistently to realize extra returns. Obviously, the last situation is a purely theoretical one since if a strongly efficient market were to exist, trading would be meaningless in it (as also a book on trading!).

  Looking at how many people work in the trading industry around the world we might well be inclined to say that, in general, financial markets are far from being efficient. But, what is a market in practice? Is it possible that a market can be considered efficient for a certain asset class and not for another? It can happen that information fully reflected into a certain security's price (and hence irrelevant for its better prediction) can be useful to better predict the future price of an other security. It can be that (especially in those markets characterized by a mix of financial and industrial investors) market segmentation allows for an inefficient mechanism of transmission of information and consequently potential excess profits.

  A full understanding of the degree of efficiency of the market we are operating in, conditional on the information set we are endowed with, allows us to understand which trading activity is worth setting up and what is the best way of allocating our risk capital. It is interesting to analyze in depth and specify the concept of market efficiency within different market sectors in order to verify the concrete possibility of making money out of our energy trading activity.

  1.1.2 Informational and Mathematical Implications

  So far we have defined and analyzed the EMH as an information-based concept. In practice, a market is considered efficient if it is able to reflect the information flow immediately into asset price dynamics. However, we have not really formally defined the concept of information. We said that a market framework is efficient at time t with respect to a certain information set φ(t ) if revealing that information to market players will not change their future price forecast. This implies, obviously, that market players are already endowed with an information set Φ(t ) already containing φ(t ) [formally, ]. If we imagine that agents formulate their future price forecast by means of the conditional expectation operator, we may write the following expression using the Law of Iterated Expectations

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  Micro Markets Workbook

  A Market Structure Approach to Microeconomic Analysis

  • Robert A. Schwartz, Michael G. Carew, Tatiana Maksimenko(Authors)
  • 2010(Publication Date)
  • Wiley

    (Publisher)

  CHAPTER 7

  Market Efficiency

  LEARNING OBJECTIVES

  • Understand the concept of allocation efficiency. Given that economics can be defined as “the study of the optimal allocation of scarce resources among competing needs,” you should not be surprised that the efficiency of resource allocation is of fundamental importance. This chapter focuses on the ability of a market to achieve allocation efficiency (goods and services being produced in the right ways and amounts and consumed in the right amounts from a public policy point of view).

  • Comprehend the meaning of the term market failure. It is important to recognize that a micro market can fail to deliver the allocation efficiency that one might desire from a public policy point of view (and that in extreme cases, a micro market may even fail to exist). Chapter 7 enumerates 10 classic causes of market failure.

  • Understand the link between information and expectations. In an environment characterized by risk and uncertainty, information is the input that participants base their expectations on. Different participants may form identical expectations (referred to as homogeneous expectations) or have different expectations (referred to as divergent expectations). You should recognize the complexity of information, and be aware that our insights into the workings of a financial market are influenced by whether we assume that participants’ expectations are homogeneous, or that they are divergent.

  • Acquire some basic information about information. A sizable part of this chapter focuses on information that you should see as a driving force for the micro markets. In light of its importance, we consider information a factor of production. The chapter states that “information sets themselves can be enormous, incomplete, imprecise, and inaccurate, and inefficiency in the micro markets can, to no inconsequential extent, be attributed to information-related inefficiencies.” An important learning objective is to understand what this entails in greater detail.

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  Short Introduction to Corporate Finance

  • Raghavendra Rau(Author)
  • 2016(Publication Date)
  • Cambridge University Press

    (Publisher)

  151 7 Market Efficiency Learning Points ■ ■ Why is market efficiency so important? ■ ■ What does it mean for a market to be efficient? ■ ■ The types of market efficiency ■ ■ Testing market efficiency ■ ■ Evidence inconsistent with market efficiency ■ ■ Systematic investor biases ■ ■ Limits to arbitrage The last major idea in this book also focuses on information. In Chapter 6 , we allowed for the possibility that the buyer and seller of any asset may have different information regarding its true value. Here we examine if investors process the information they receive in different ways, so that the market price does not correctly reflect the fundamental value of the asset. Why Is Market Efficiency So Important? Let us start by thinking how we set prices. Suppose we want to buy an airline ticket online. What do we do? Most of us would start by using an online search engine to find prices. But do we buy the airline ticket right away? Many of us would not. We would go back the next day and search for the same ticket again. If the ticket price has gone up, we would be a little more eager to buy. We might be willing to wait an additional day, but if prices go up again on the second day, we would be much more likely to buy immediately. In contrast, if the ticket price has gone down, we would be much more willing to wait. If the ticket goes down in price yet again on the second day, we will be willing to wait even longer. In essence, what we are doing is estimating supply and demand. Rising ticket prices signal to us that there is high 152 Market Efficiency demand and low supply. Falling ticket prices signal the opposite. Companies use much the same information to make investment decisions. If prices are rising on particular types of goods, they will try to manufacture more. What all this means is that prices give us very useful information about supply and demand, expected economic growth, discount rates, volatility, and a whole host of other macroeconomic factors.

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  Personal Finance and Investments

  A Behavioural Finance Perspective

  • Keith Redhead(Author)
  • 2008(Publication Date)
  • Routledge

    (Publisher)

  Market Efficiency

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  Chapter 23Market efficiency: Concepts and weak form evidence

  OBJECTIVE

  The objective of this chapter is to provide knowledge of:

  1. The concepts of weak, semi-strong, and strong form informational efficiency.
  2. Evidence of arbitrage failures.
  3. Empirical evidence on the weak form of the efficient market hypothesis.
  4. Evidence on overshooting and mean reversion.
  5. Evidence on momentum and contrarian strategies.
  6. The implications of market efficiency for investment analysis.

  TYPES OF EFFICIENCY

  Market efficiency can be divided into three types: allocative efficiency, operational efficiency, and informational efficiency. Allocative efficiency is concerned with whether funds are directed to their most productive uses. This is mainly a primary market issue; the primary market being the market in which borrowers issue securities and receive payment from the initial investors (the word ‘borrowers’ here includes companies that raise money by issuing shares although, strictly speaking, share issuance is not borrowing). Allocative efficiency is concerned with the issue of which borrowers receive the finance. An allocatively efficient market is one in which the available funds go to the borrowers who will make the most productive use of them. Allocative efficiency is not the main concern here. However, it is important to be aware that allocative efficiency is dependent on operational and informational efficiency.

  Allocative efficiency is dependent upon securities (shares and bonds) being accurately priced. Accurate pricing requires informational efficiency. If securities are not accurately priced, investors could direct their money to uses that are not the most productive. For example during 1999 and early 2000 shares in Internet-related companies were seriously overpriced. For those people establishing Internet-related companies, the proceeds from share sales heavily exceeded the costs of establishing the companies. So there was a great incentive to set up Internet-related companies. Too many Internet-related companies were created and most of them subsequently failed. The overpricing of shares issued by Internet-related companies had caused too much money to be invested in such companies. Much of this money could have been invested more productively elsewhere.

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  Handbook of Market Risk

  • Christian Szylar(Author)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  hapter Two

  The Efficient Markets Theory

  I'd be a bum on the streets with a tin cup if the markets were efficient.

  —Warren Buffett

  In this chapter we will examine a fundamental question about financial markets. This question has raised a lot of debates among practitioners and academics about its reality. The question is about market efficiency, along with the following questions: How do financial markets match providers with users and, more importantly, how efficiently does the market determine prices?

  The financial markets perform much the same function as the markets for other goods and services. They bring large numbers of buyers and sellers together, thus relieving each party of the need for a potentially long and expensive search for a counterpart with exactly equal but opposite needs to his or her own. The existence of such a market improves price transparency, encourages competition, and improves efficiency generally.

  But the financial markets can also be highly volatile. The stock market is possibly the most volatile of them all. Some investors will win and some will lose. Is it just a matter of luck or skill? Or does it depend on a mixture of the two?

  A fair return on investment is one that offers the investor just the right level of compensation for the expected risk of the investment (in addition to the time preference rate and an adjustment for expected inflation). But why is it so important at the end whether market prices for investments in fact offer fair returns? Could we argue that the pricing of investments is a zero-sum game in which one investor's loss is another's gain? For every investor who loses by buying at the top of the market and selling at the bottom, there must be another who profits by doing the opposite. So we can argue that if a particular investment offers either an excessive or an inadequate return, total income and wealth are neither increased nor reduced but simply redistributed among the market participants.

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  Hans-Michael Geiger- Informational Efficiency in Speculative Markets- A Theoretical Investigation (Volume 29.0)

  • (Author)
  • 2018(Publication Date)
  • Peter Lang International Academic Publishers

    (Publisher)

  7 CHAPTER I The Fundamental Issue: Efficiency in Market Economies This part deals with the terminus technicus 'efficiency' in an extensive sense: Efficiency related to the performance of market according economic theory. The investigation is mainly conducted using the terms 'allocational efficiency' (A-efficiency), and 'informational efficiency' (I-efficiency). Occasionally, the terms 'allocation efficiency' or 'information efficiency' will be used. Because in economic theory these above-cited notions are already widely applied carrying special meanings, the following exposi-tion provides a framework of definitions. A market is considered to be a composite unit of two related sub-systems. These subsystems are referred to as 'allocation system' (A-system) and 'information system' (I-system). Market System /Allocation System ~Info=ation Syst= The A-system comprises the traditional conception of market eco-nomies as based upon autonomous decisions of many legally inde-pendent economic agents. Thus one may think in terms of producers and consumers, of suppliers and demanders of labour and of goods and services. However, we only deal with the relations that are usually assessable in termini of prices. In order to clearly study these market conditions, we put on glasses to 'colour the Hans-Michael Geiger - 978-3-631-75572-3 Downloaded from PubFactory at 01/11/2019 03:27:17AM via free access 8 world' in economic categories thus blocking out all other possib-le interactions 11 • The fact that this type of strategy allows to focus on particular elements by hampering the digression to incidentals is the rational justification for all kinds of 'a priori'-views. This is usually called 'Werturteil im Basis-bereich'. On the other hand, it bears the risk of a narrowed horizon, which suppresses access to better or !!lore appropriate forms of explanation.

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  The Economics of Property and Planning

  Future Value

  • Graham Squires(Author)
  • 2021(Publication Date)
  • CRC Press

    (Publisher)

  It has so far been considered that markets can be conceptualised, although the workings of the market are not as clear and simple as classical economic market theory would suggest. As described earlier, there are limitations of not being able to internalise all costs and benefits, and third party external costs and benefits need to be recognised outside of the market transaction. Further market difficulties are their failure to efficiently allocate resources, where conventional free-market theory would suggest is when long-term equilibrium of supply and demand is always achieved. ‘Market Failure’ is the key concept for discussion here and is where the market fails to achieve an efficient allocation of resources. This inefficient allocation of resources certainly applies to environmental resources in their use, production, and consumption within places.

  Table 11 demonstrates the five main reasons why markets fail. The occurrence of monopolies is one way in which the efficiency of markets is restricted, as one supplier in the market would mean that they would be able to fix prices at a higher rate due to lack of competition. Lack of competition may be because there are barriers to entry into the market, for instance the telecommunications infrastructure has often been monopolised by companies. This monopoly power and domination in the telecommunications market has meant that prices are held artificially high without the ability of competitors to enter the market. This has prompted governments to step in and ensure that companies act in the interest of the consumers by breaking into smaller demerged entities with a lower percentage of market share.

  Table 11 Types of Market Failure and Descriptors

  Type of Failure	Descriptors
  Monopolies(including natural monopoly)	• Few producers relative to the size of the market
  Externalities	• External social and environmental costs, in addition to internal market costs
  Public goods (and common property resources)	• No exclusive and non-rival • Owned by no one and used by anyone
  Weak property rights	• Inability of institutions to establish well-defined property rights – market doesn’t function in a complete rational and bounded process
  Asymmetric information	• Producers do not have the same information • Generates moral hazards and adverse selection

  Source: Author

  Monopolies also occur for very practical reasons such as the strategic benefits of being a natural monopoly. A natural monopoly is where it makes sense to have only one producer in a certain market, especially if the addition of one extra unit is made means that a unit cost is lower. An example of a natural monopoly within a place is the utilities that service properties such as electricity, gas, water, and sewage. It would not make economic sense in terms of efficiency if several companies built these service infrastructures, as this would mean that there would be four or five cables and pipes servicing properties in a place when only one would suffice. The practical economic solution would be to have a well-regulated infrastructure that allowed service providers to lease and compete for the single physical infrastructure. Transport links between places would also be argued to form a natural monopoly and hence demonstrate that a complete free-market approach would be inefficient. The rail network that connects cities within national boundaries is often owned by a regulated coordinating body that lease out parts of the track to competitive tender.

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