A New Measure of Market Inefficiency
16 Pages Posted: 26 Aug 2007
Date Written: August 24, 2007
An oft stated corrollary, sometimes taken as its definition, of the Efficient Markets Hypothesis is that in an efficient market it should not be possible to systematically make excess or abnormal returns. This begs the question of excess or abnormal relative to what? Traditional benchmarks either fail to distinguish between trading returns and market returns, or are dependent on an associated asset pricing model, thus leading to the joint-hypothesis problem. In this paper we discuss a purely empirical measure - Excess Trading Returns - derived from the difference in profits associated with an agent portfolio where one or more trades were executed relative to a Buy-and-Hold portfolio where they were not, the Buy-and-Hold benchmark being dynamic and/or unique to the agent. With this measure in hand we introduce the relative inefficiency associated with a pair of agents, agent groups or trading strategies and from this define an Inefficiency Matrix that can provide a complete empirical characterization of the inefficiencies inherent in an entire market.
Keywords: efficient markets hypothesis, excess returns, dynamic benchmark, inefficiency
JEL Classification: G14, G11
Suggested Citation: Suggested Citation
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