Inefficient Market

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Inefficient Market Definition

In an inefficient market, the financial asset does not display or reflect its fair and true market value. Also, do not obey the concept of an efficient market hypothesis. The efficient market hypothesis states that the financial asset traded in the financial system always displays its true and fair value to the participants or the market.

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  • An inefficient market is when the financial asset does not indicate or reflect its fair and accurate market value.
  • In addition, it does not follow the efficient market hypothesis concept that states that the financial asset traded in the financial system always shows its true and fair value to the market or participants.
  • The types of an inefficient market are market efficiency, absence of information, delayed reaction to the news, and presence of arbitrageurs and speculators. 
  • It is assumed that the markets are efficient and work as per the efficient market theory. Inefficient markets, information, and news regarding the assets are accessible effortlessly. 

Types of Inefficient Market

The following are types of inefficient markets.

Inefficient-Market

#1 - Market Efficiency

The inefficient market has been derived from market efficiency. Market efficiency states that the prices of the asset display a fair market value basis the available information and news. Since data is readily available inefficient markets, the assets are never undervalued, and there is no method to beat market expectations. In addition, since the market is efficient, it would not have arbitrageurs and speculators as market participants.

#2 - Absence of Information

In inefficient markets, the information that influences the prices of the assets is not readily available. Hence, it becomes difficult to determine or predict the correct prices of the assets. That causes the financial holdings not to display their true value resulting in a weak market.

#3 - Delayed Reaction to News

There could be certain types of news that can influence the prices of the assets. Inefficient markets, the prices of assets quickly and dynamically reflect the available information related to the asset. On the other hand, the inefficient markets show no impact on the value of assets as and when the news is published, thereby giving a delayed reaction and resulting in an inefficient market.

#4 - Presence of Arbitrageurs and Speculators

The arbitrageurs are entities that take advantage of the mispricing of the assets and earn a riskless profit on such a strategy. The speculators are individuals who gain access to high-level news related to the assets and use them to speculate on the prices of the assets. Inefficient market, there is no asset mismatch, and the information is readily available to all market participants.

However, this situation is the opposite of inefficient markets where arbitrageurs and speculators dominate the markets, thereby influencing the prices of the assets.

Examples of Market Inefficiency

The following are examples of market inefficiency.

Example #1

Suppose there is an asset whose supply varies invariably with its demand in the financial markets. As a result, it causes the equilibrium position for supply and demand for the economic asset decreases or deteriorates. That may further result in undervaluation or overvaluation of the prices of assets due to a lack of equilibrium in the supply and demand of the assets. Hence, this gives rise to inefficient markets.

Example #2

Suppose stock ABC trades in both NYSE and NASDAQ exchanges. It currently trades at $10 on NYSE and $10.95 on NASDAQ. Inefficient markets, such as asset mispricing, do not exist due to the easy availability of information.

However, in an inefficient market, this situation of asset mispricing exists. Therefore, it becomes an opportunity for the arbitrageur to derive riskless profit. For example, the arbitrageur may buy the stock at $10 on NYSE and sell the stock at $10.95 on NASDAQ to derive a riskless profit of $0.95 per share.

Example #3 - Practical Application

The dotcom bubble that occurred in 1990 is an example of market inefficiency. The dot-com or internet is a company whose business is conducted through websites and thereby derives revenues from such operations. Consequently, US-based technology equity stock prices rose unprecedentedly and exponentially in the dotcom bubble.

The price inflation in the stock prices of the equities was due to over-speculation and lack of monitoring by the investors when they invested and took positions in such stocks. It resulted in a massive deterioration in the overall value of the assets when the dotcom bubble finally burst. The speculative bubbles are hard to recognize but reach their threshold or peak; such bubbles burst to make them more evident and probable.

Advantages of an Inefficient Market

  • The market participants may earn some excess returns due to inefficiencies present in the market.
  • There may be delayed reactions to the news that may reflect the asset prices giving the speculators and small-time traders enough time to liquidate their positions and earn good profits.
  • Inefficient markets give rise to asset mispricing, which the arbitrageurs can use to derive riskless profit.

Disadvantages

  • Market participants may tend to lose money very quickly and easily.
  • There is always a probability that asset bubbles and speculative-based bubbles may harbor or are around the corner in inefficient markets in inefficient markets.
  • The demand and supply of the asset tend to vary, invariably leading to a price mismatch in the assets held.

Important Points

  • The financial markets or asset-based market tends to appear as efficient.
  • However, since the procurement of information and news that influences asset prices is hard to access, this transforms efficient financial markets into inefficient markets.
  • There are assets whose prices are fairly undervalued and overvalued in an inefficient market.
  • The financial markets may reflect the impact of news on the prices of assets after a certain level of delay.

Conclusion

It is assumed that the markets are efficient and operate according to the efficient market theory. Inefficient markets, the information, and news concerning the assets are readily available. There are no assets whose prices are either undervalued or overvalued; all the assets are assumed to be equally priced. There is no such presence of speculators and arbitrageurs’ inefficient markets. It is a platform where the assets are not fairly and similarly priced.

There may be assets that are undervalued, and there may be assets that are overvalued. Due to such scenarios, few market participants may earn high and excess returns. In addition, the arbitrageurs tend to make riskless profits in inefficient markets as these markets may have assets whose prices may be mismatched across platforms. As a result, speculative-based bubbles may be created in inefficient markets.

Frequently Asked Questions (FAQs)

Is real estate an inefficient market?

Yes, real estate is a weak market where prices are determined through the meetings of a buyer and seller, two entities or people who make decisions based on the situation.

What are socially efficient and inefficient market outcomes?

Socially efficient market outcomes refer to society's most favorable resource distribution considering every external and internal advantage and cost. In comparison, an inefficient market refers to a market that fails to include all the accessible information in an asset's fair price.

What are the reasons for an inefficient market?

The reasons for an inefficient market are irregularities in information, market attitude, externalities, market power, lack of competition, business transaction costs, and people's emotions.

Why, in an inefficient market, are securities typically in equilibrium?

In an inefficient market, market securities are typically in equilibrium because they are priced adequately, and the expected returns are similar to their needed returns.