A measurement of the extent of market imperfections between markets and applications

Abstract

Traditionally, market imperfections are measured separately. In dealing with the impacts of market imperfections on a financial theory, financial researchers often modify the theory by incorporating one type of market imperfections into the theory, one by one, and then derive a new modified formula. The major problem with this approach is that when considering a type of market imperfections, the new modified formula still ignores the effects of other types of market imperfections. Another problem is that the modified formula is often tedious. Following the concept of degree of market imperfection in Hsu and Wang (2004), this article aims to derive a more easy measurement of market imperfections between markets, discuss some useful applications and provide one of empirical tests. The degree of market imperfection between markets can be applied at least to the following areas: (1) theoretical model building for pricing derivatives in imperfect markets, (2) predicting the deviations of the actual derivative prices from their theoretical prices based on the model of perfect market assumptions and (3) showing the extent of arbitrage activities between markets.