Reconsidering Market Efficiency: A Tale of Two Exchanges
24 Pages Posted: 8 Dec 2011 Last revised: 16 Dec 2011
Date Written: November 19, 2009
The efficient markets hypothesis argues that the price of a financial asset reflects available information about that asset. Competing theories argue that other factors, including investor behavior, can cause asset prices to diverge from the efficient price leading to “bubbles.” We argue that the governance of market institutions plays a profound role in achieving market efficiency. In particular, we note that until recently, both the New York Stock Exchange and the NASDAQ were non-profit firms. We then identify an objective function for each of these firms and argue that the NYSE had an incentive to produce an informationally efficient marketplace for equities whereas the NASDAQ benefited from inefficiency. We test our hypothesis using a natural experiment, the IPO of the NYSE in 2006, and find that bid-ask spreads on the NYSE were consistently lower than the NASDAQ but then converged after demutualization. We believe that our approach helps resolve an apparent tension between competing theories of market behavior and contributes an analytical framework from which to consider regulatory changes.
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