This came up in class the other day, so I figured even though the Ofek, Richardson, and Whitelaw paper itself has been around for a while (it has been accepted but has yet to be published at the JFE), I would do a quick recap of the discussion and add the links to the actual paper in question.
We were speaking about market efficiency, and suggesting that if markets were not efficient, the inefficiencies could be from two main sources: 1. True irrationality or 2. market imperfections such as a lack of liquidity, short sales constraints, poor information, etc.
While acknowledging group irrationality can develop, its existence is (IMO) quite rare and a function of a lack of differing views. Hence the more participants in a market, the less likely group irrationality will develop.
Market imperfections can be broadly classified as transactions costs (lack of information, a lack of liquidity, high trading costs, short sale restrictions etc). These imperfections allow any temporary mispricing to continue by raising the cost of arbitraging the errors away. Additionally, to the degree that the imperfections shrink the size of the market, transaction costs also help to allow the group “irrationality” mentioned above to both develop and to persist.
It should be noted that the existence of these conditions does not guarantee inefficiencies. And even if the conditions and inefficiencies do exist, it very well may be that the market is still better than any other allocation mechanism. (So relax, I am still a believer in largely efficient, albeit not perfect, markets.)
Rather than consider this question from the emotionally charged debate on market efficiency, consider the question to be: “if I had to look for inefficiencies, this is where I would look.”
In a forthcoming JFE article, Ofek, Richardson and Whitelaw investigate the idea that imperfections may limit arbitrage in conjunction with the put-call parity relationship. (Put call parity states that the put + stock = call + PV (strike) (remember: all positive at Park and Shop ;) ).
This put-call relationship should always hold in equilibrium. The authors find that it does not hold in the presence of short sale restrictions.
In their words:
…consistent with the theory of limited arbitrage, we find that the violations of the put-call parity no-arbitrage restriction are asymmetric in the direction of short sales restrictions. These violations persist even after incorporating shorting costs and/or extreme assumptions about transactions costs (i.e., all options transactions take place at ask and bid prices).
Need more “evidence”? I will ignore the preponderance of existing literature on the topic (ask if you want some more) and give you some “real time” research. I am currently working on a paper with Jonathan Godbey and Rodney Paul that looks at this idea along different lines. We look at the predictive ability of implied volatilities of equity options. While the paper is still a ways off (hopefully it will be done in January), preliminary results suggest fairly convincingly that the efficiency of the option market (as measured by the ability to forecast future volatility) is strongly tied to option liquidity. That is, for active options, implied volatility works well, for illiquid options, it does not.
So what this all mean? I will give the same conclusion that ended our class discussion:
“From a societal point of view, we should strive to reduce market imperfections and lower transactions costs: Reduce barriers to entry, end short sale restrictions, increase competition. Why? Because where there are significant imperfections, the market prices we see are less likely to be “correct” and consequently allocational efficiency is suspect.
...Are markets perfect? No. Are they pretty good? Yes. Are they better in some incidences than others? Yes. It is this last area where we may be able to do something. As an investor (and not just in financial securities), look for areas where you have a sustainable advantage. It is unlikely, although not impossible, that this is in the area of financial markets. In the financial markets, you can earn a very good return, but it is unlikely that actually beat the market on a risk adjusted basis. "
The Ofek, Richardson and Whitelaw paper is available at:
Forthcoming JFE version remember it will be taken down when the paper goes to print
FEN-SSRN (working copy version)