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Article
The Mechanisms of Market Inefficiency: An Introduction to the New Finance
Cornell Law Faculty Publications
  • Lynn A. Stout, Cornell Law School
Document Type
Article
Publication Date
7-1-2003
Keywords
  • Efficient market theory,
  • Homogeneous investor expectations,
  • Effective arbitrage,
  • Investor rationality,
  • Efficient Capital Market Hypothesis,
  • ECMH
Abstract
During the 1970s and early 1980s, the Efficient Capital Market Hypothesis (ECMH) became one of the most widely-accepted and influential ideas in finance economics. More recently, however, the idea of market efficiency has fallen into disrepute as a result of market events and growing empirical evidence of inefficiencies. This essay argues that the weaknesses of the efficient market theory are, and were, apparent from a careful inspection of its initial premises, including the presumptions of homogeneous investor expectations, effective arbitrage, and investor rationality. By the same token, a wide range of market phenomena inconsistent with the ECHM can be explained using market models that modify these three assumptions. In illustration, this Article explores three important strands of today's finance literature: (1) the expanding body of work on asset pricing when investors have heterogeneous expectations; (2) recent theoretical and empirical scholarship on how and why arbitrage may move certain types of publicly available information into price more slowly and incompletely than earlier writings suggested; and (3) the exploding literature in "behavioral finance," which examines what happens to prices when market participants do not all share rational expectations. Taken together, these three bodies of work show signs of providing the essential framework on which a new and more powerful working model of securities markets can be built.
Comments

This article was written prior to the author's affiliation with Cornell Law School.

Publication Citation
Published in: Journal of Corporation Law, vol. 28, no. 4 (Summer 2003).
Citation Information
Lynn A. Stout. "The Mechanisms of Market Inefficiency: An Introduction to the New Finance" (2003)
Available at: http://works.bepress.com/lynn_stout/13/