Arbitrage Risk and Market Efficiency – Applications to Securities Class Actions

Abstract:     
Measuring the efficiency of the market for a stock is important for a number of reasons. For example, it determines the necessity for an investor to acquire expensive additional information about a firm, and it is a critical factor in class certification in a securities class action. We provide a general methodology to measure the market efficiency percentile for a stock for any relevant period. We apply this methodology to calculate arbitrage risk for each U.S. exchange-listed common stock for every calendar year from 1988 to 2010. We find that market efficiency is significantly affected by turnover (negatively), the number of market makers for Nasdaq stocks (negatively), and serial correlation in the market model of the stock (positively). These findings seem inconsistent with “conventional wisdom,” but we show that our findings are consistent with economic logic. The relations between market efficiency and market capitalization (positive), bid-ask spread (negative), institutional ownership (positive), and explanatory power of the relevant market model (positive) are consistent with conventional wisdom. The impact on market efficiency of the number of securities analysts following a stock and the public float ratio of a stock are of ambiguous significance.

Number of Pages in PDF File: 26

Keywords: market efficiency, arbitrage risk, turnover, trading volume, market capitalization, public float, institutional ownership, securities analysts, market makers, serial correlation, bid-ask spread, market model, Cammer factors, class certification, securities class actions

JEL Classification: G14, K22

working papers series