What is Mispricing?
Mispricing causes a divergence between the market price of a security and the fundamental value of that security. The law of one price states that the market price of a security is equal to the present discounted value of all cash flows generated by the security. However, it is not always the case as asset prices can sometimes diverge from their fundamental values. The divergence can be due to a financial crisis or a current event in the economy.
While the shifts in asset prices can lead to arbitration opportunities, they also help economists understand what causes the mispricing of the asset. It can be due to a macroeconomic issue such as financial or capital institutions that trade the assets, or it can be due to the specific characteristics of the individual assets at the microeconomic level.
Mispricing in the Market
- The probability that an asset is mispriced increases with the total number of mispriced assets in the market. A lot of commonalities exists between the deviation of asset prices and their fundamental values. It shows that with mispricing, there is a level of systematic risk for investors in financial markets. Along with the systematic risks, mispricing can cause detrimental effects in markets through the destabilization of dealer funding costs.
- The direct correlation between mispricing and dealer funding costs show that investors face capital constraints in financial markets. The constraints are the primary reason for the mispricing of stocks in the market.
- Although the principle states that asset prices should be equal to the present value of the cash flows, mispricing proves that asset prices are often driven by factors that are unrelated to the cash flow or discount rate of the stocks.
Reasons for the Divergence in Asset Prices
Many theoretical models exist to a reason why the prices of assets diverge from their fundamental values. It can be due to financial, capital, or liquidity constraints. They are described as follows:
1. The ability to obtain funding
The ability of the participants in the market to obtain capital is a major reason why asset prices can be different from their fundamental values. The lack of funding causes assets to function independently from their fundamentals and does not allow the investor to arbitrage the mispricing.
2. The capital is moving slowly
The slow movement of investment capital to the number of trading opportunities is a cause for mispricing. Sometimes, the arrival of capital to meet an investment opportunity can be delayed by a few seconds (an equity market) or by a few months (risk insurance market).
Either way, it creates demand and supply shocks in the market because there is too little capital available to absorb the shock. The shocks cause asset mispricing in the economy. Eventually, the capital will enter the market to meet the investment need and the asset mispricing will be reversed.
3. Intermediary capital
Many theories suggest that there is a direct correlation between asset prices and the capital provided by financial intermediaries. In such a case, asset mispricing can be caused when there are constraints on raising capital through the sale of shares (equity capital). For example, an arbitrageur can provide liquidity to other traders who are looking to reduce risk exposure; however, if their ability to provide insurance is constrained by equity capital, it can exert a large impact on the asset prices.
While the theory is similar to funding liquidity in terms of capital constraints, the key difference is the way the capital is raised. Funding liquidity refers to debt capital constraints, while, intermediary capital refers to equity capital constraints.
4. The effects of liquidity
Illiquidity refers to the inability to sell stocks or shares without suffering a major loss. It can contribute to asset mispricing. Investors often incur high transaction costs while trading securities. It creates a difference between the cash flow of the security and the amount of money the investor actually receives. The disparity can affect the market prices of stocks.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: