How Does Mispricing Vary Across Market Capitalization and Liquidity Segments?

Abstract

Market mispricing is where the prices of a stock in the market appear not to correlate with its intrinsic or fundamental price. In traditional financial theory, and specifically the Efficient Market Hypothesis, deviations of this kind are supposed to be uncommon and short lived since rational investors are supposed to swiftly integrate the accessible data in prices. Empirical evidence has however indicated that mispricing is not present in all market’s segments equally. Capitalization and liquidity variations seem to have an effect on the level of stock price accuracy. Market capitalization ranks firms as big, medium and small-cap companies in terms of their overall market worth whereas liquidity is the way a stock can be traded without causing a tremendous movement in its price. Pricing anomalies have been identified to be more intense in small-cap and illiquid stocks than in the large-cap and well liquid stocks. The average returns have always been better than forecasted by the conventional asset pricing models when using smaller firms as they are known to give higher returns (Banz, 1981). On the same note, lower liquidity is associated with greater expected returns of stocks, thus liquidity is important in pricing assets (Amihud, 2002). In this paper, the variation of mispricing between market capitalization and liquidity segment is reviewed. It deals with the propositions of market efficient explanations, information asymmetry, and structural market restriction. The article claims that mispricing is more intense in smaller and less liquid stocks because of the presence of less or no flow of information, transaction costs and the lack of arbitrage mechanisms.