Three essays on mispricing and market efficiency

This dissertation consists of three essays. The first essay studies the impact of indexing on stock price efficiency. Indexing has experienced substantial growth over the last two decades because it is an effective way of holding a diversified portfolio while minimizing trading costs and taxes. In this paper, we focus on one negative externality of indexing: the effect on efficiency of stock prices. Based on a sample of large and liquid U.S. stocks, we find that greater indexing leads to less efficient stock prices, as indicated by stronger post-earnings-announcement drift, greater deviations of stock prices from the random walk and greater return predictability from lagged order imbalances. We conjecture that reduced incentives for information acquisition and arbitrage induced by indexing are probably the main cause of the degradation in price efficiency, but we find no evidence supporting a direct impact from passive trading or any effect through liquidity. The second essay investigates the effect of price inefficiency on idiosyncratic risk and stock returns. I finds that price inefficiency in individual stocks contributes to expected idiosyncratic volatility. If idiosyncratic risk is priced, greater price inefficiency could be associated with higher expected returns. Consistent with this hypothesis, this paper then finds a positive relation between price inefficiency and future stock returns. This return premium of price inefficiency is not explained by traditional risk factors, illiquidity, or transactions costs. It is also evidently different from the return bias related to Jensen's inequality. This paper thus provides new insights about the determinants of expected stock returns, and new supporting evidence that idiosyncratic risk is priced. The third essay examines whether the upward return bias generated by Jensen's inequality could lead to better performance of equally-weighted (EW) indexes than value-weighted (VW) index when stock prices are not fully efficient. We find that, for a wide range of U.S. stock indexes, EW indexes deliver better four-factor adjusted returns than VW ones do even after deducting transaction costs. Consistent with our hypothesis that the outperformance of EW indexes comes from mispricing, we find that this outperformance concentrates in stocks with greater mispricing, as measured by deviation of stock prices from random walk. Findings in this essay not only imply a potentially winning investment strategy, but also provide new insight into a long-term debate on causes of the outperformance of the EW indexes.

Name thesis:degree_name

Ph. D.

Level thesis:degree_level

doctoral

Discipline thesis:degree_discipline

Business, Finance

Department dc:contributor.department

Finance, Insurance and Business Law

Grantor dc:publisher

Virginia Tech

Year dc:date.issued

2014

Author dc:creator

• Qin, Nan

Chair dc:contributor.committeechair

• Singal, Vijay

Committee members dc:contributor.committeemember

• Kadlec, Gregory B.
• Keown, Arthur J.
• Kumar, Raman

• indexing
• index funds
• ETFs
• passive institutional investors
• stock price efficiency
• passive trading
• trading strategy
• idiosyncratic risk
• equally-weighted index
• stock return bias
• Jensen's inequality

Statement dc:rights

• In Copyright

Licence dc:rights.uri

• http://rightsstatements.org/vocab/InC/1.0/

Dc Identifier Other

vt_gsexam:3407

OAI identifier oai:identifier

oai:vtechworks.lib.vt.edu:10919/49671