A New Measure of Market Inefficiency

16 Pages Posted: 26 Aug 2007

See all articles by Christopher R. Stephens

Christopher R. Stephens

Universidad Nacional Autonoma de Mexico

H.A. Benink

Tilburg University

Jose Luis Gordillo

Universidad Nacional Autónoma de México (UNAM)

Juan Pablo Pardo-Guerra

London School of Economics and Political Science

Date Written: August 24, 2007

Abstract

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

Stephens, Christopher R. and Benink, Harald and Gordillo, Jose Luis and Pardo-Guerra, Juan Pablo, A New Measure of Market Inefficiency (August 24, 2007). Available at SSRN: https://ssrn.com/abstract=1009669 or http://dx.doi.org/10.2139/ssrn.1009669

Christopher R. Stephens (Contact Author)

Universidad Nacional Autonoma de Mexico ( email )

Circuito Exterior
A. Postal 70-543
Mexico, 04510
Mexico
(52)-555-622-4692 (Phone)
(52)-555-622-4693 (Fax)

Harald Benink

Tilburg University ( email )

P.O. Box 90153
Tilburg, DC Noord-Brabant 5000 LE
Netherlands

Jose Luis Gordillo

Universidad Nacional Autónoma de México (UNAM)

Circuito Mario de la Cueva s/n
Lomas de las Palmas, 52760
Mexico

Juan Pablo Pardo-Guerra

London School of Economics and Political Science ( email )

Houghton Street
WC2A 2AE London, England
United Kingdom