A New Measure of Market Inefficiency

• Main Authors: Christopher R. Stephens, Harald A. Benink, José Luís Gordillo, Juan Pablo Pardo-Guerra
• Format: Article
• Language: English
• Published: MDPI AG 2021-06-01
• Series: Journal of Risk and Financial Management
• Subjects: efficient market hypothesis (EMH); excess trading returns; investor’s behaviour; behavioural finance
• Online Access: https://www.mdpi.com/1911-8074/14/6/263

Financial crises, such as the Great Financial Crisis of 2007–2009 and the COVID-19 Crisis of 2020–2021, lead to high volatility in financial markets and highlight the importance of the debate on the Efficient Markets Hypothesis, a corollary of which is that in an efficient market it should not be possible to systematically make excess returns. In this paper, we discuss a new empirical measure—Excess Trading Returns—that distinguishes between market and trading returns and that can be used to measure inefficiency. We define an Inefficiency Matrix that can provide a complete, empirical characterization of the inefficiencies inherent in a market. We illustrate its use in the context of empirical data from a pair of model markets, where information asymmetries can be clearly understood, and discuss the challenges of applying it to market data from commercial exchanges.