Chapter 4Efficient Securities

Markets

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Outlines• Efficient Securities Markets• Implications of Efficient Securities

Markets for Financial Reporting• The Informativeness of Price• A Capital Asset Pricing Model• Information Asymmetry• An Example of Full Disclosure

Chapter 4 Efficient Securities Markets

4.2 Efficient Securities Markets

• The Meaning of Efficiency– An efficient securities market is one

where the prices of securities traded on that market at all times “properly reflect” all information that is publicly known about those securities.

Efficient Securities Markets , cont’d

• Definition (Semi-strong form)– At all times…– Fully reflect...– All publicly available information…– A relative concept

• Efficiency defined relative to a stock of publicly available information

Efficient Securities Markets , cont’d

• Market prices are efficient with respect to publicly known information

• The market efficiency is a relative concept• The investing is fair game if the market is

efficient• Given market efficiency, a security’s market price

should fluctuate randomly over time– The reason why price fluctuations are random is

that anything about firm that can be expected– The only reason that prices will change is if some

relevant but unexpected information comes along

Forecasting outcomes of football games

1966 1967

1968

Total forecasters (including consensus)Total forecasts made per forecasterRank of consensus Median rank of forecastersRank of best forecasters:J.Carmichael(1966)D.Nightingale(1966)A.Biondo(1967)H.Duck(1968)

15180

1(tie)8

1(tie)

1(tie)78

15220

28

8111

10

16219

28.5

16561

How do market prices fully reflect all available

information?

Market Response to Earnings

• Ballard Power Systems Inc.– 4th Quarter loss doubles compared with

same quarter of previous year– R & D spending up– revenue doubles

• Is rise in share price to $189 “efficient?”

Question

• Two firms, of the same size and risk, release their annual reports on the same day. It turns out that they each report the same amount of net income. Follow the release, the share price of one firm rose strongly while the other rose hardly at all.

• Why?

Question, cont’d

• The differing market response could be explained by a difference in the market’s expectations of earnings.

• Another reason could be a difference in the quality of earnings. The firms may have used different accounting policies.

• Finally, the informativeness of price could have differed between the two firms.

4.3 Accounting Implications of Securities Market

Efficiency• W. Beaver, “What Should Be the FASB’s

Objectives,” Journal of Accountancy (1973)– Full disclosure, incl. acc. policies– Accounting policies do not matter (unless

cash flow effects)– “Naïve” investors price-protected– Accountants in competition with other

information providers

4.4 The Informativeness of Price

• A Logical Inconsistency– Fully Informative Share Prices

• If prices fully reflect available information, there is no motivation for investors to acquire information; hence, prices will not fully reflect available information.

• No role for accounting information

– Partly Informative Share Prices • Concept of noise traders• Expected value of noise = 0• Market efficient in expected value sense• Role for accounting information

The Informativeness ofShare Price I

• Fully informative share prices– No one would bother to gather information,

since can’t beat the market– If no one gathers information, share prices

will not reflect all publicly available information

– Hence the logical inconsistency

The Informativeness of Share Price II

• A way out of the logical inconsistency– Noise trading

• Expected value of noise = 0• Share prices still efficient, but in an expected

value sense

The Informativeness of Share Price III

• Partially informative share prices– Share prices not fully informative since

market price may be “wrong” in presence of noise

– Share prices now only partially reflect publicly available information—they also reflect noise

– Investors now have incentive to gather information

4.5 A Capital Asset Pricing Model

• CAPM– E(Rjt) = Rf(1 - βj) + βjE(RMt)

(4.2)– How does accounting information

affect share price? See Eq’n (4.2) in text: 1

)()(

1,

tj

jtjtjt

P

DPERE (4.2)

How Does Accounting Information Affect Share

Price? • In Equation (4.2), accounting information affects

the numerator E(Pjt + Djt)

• E(Rjt) does not change, since only firm specific component in CAPM is beta

• Thus Pj,t-1 (i.e., current share price) must change in the denominator of Equation 4.2 to keep (Ejt) unchanged

CAPM, Cont’d• It bring out clearly how share price

depend on investor’s expectations of future share price and dividends– If these expectations change (the

numerator of Equation 4.1), current price Pj,t-1 (the denominator) will immediately change to reflect these new expectations

1,

1,

tj

tjjtjt

P

PDP

jtR (4.1)

CAPM, Cont’d

• It provides us with a way of separating the realized return on a share into expected and unexpected components

– Market model – Rjt = σj + βj RMt + εjt

• “Rjt” is the realized return • “σj + βj RMt” is the beginning of period expected

return• “εjt” is the unexpected or abnormal return

CAPM, Cont’d

• It provides a convenient way to estimate a stock’s beta– By obtaining past data on Rjt and RMt , the

coefficients of the regression model can be estimated by least-squares regression

4.6 Information Asymmetry

• The fundamental value of a share– The value of a firm’s share on an efficient

market if all information about the firm is publicly available (i.e., no inside information)

• Inside information– Information about the firm that is not

publicly available

4.6 Information Asymmetry (continued)

• The adverse selection problem• Insiders may exploit their information

advantage to earn profits at the expense of outside investors

• Inside information a source of estimation risk for investors

4.6 Information Asymmetry (continued)

• Investor reaction to estimation risk– The lemons problem (Akerlof (1970))

• Would you buy a used car from someone you do not know?

– Would you buy a share in the presence of inside information?

• No, withdraw from market, market collapses (e.g., post-Enron)

• Yes, but pay less, to protect against estimation risk• Note: estimation risk cannot be diversified away. Why?

4.6 Information Asymmetry (continued)

• Effect of estimation risk on share prices– Efficient market price includes a “discount”

for estimation risk• i.e., investors demand a higher return

– CAPM overstates cost of capital, since ignores estimation risk

4.6 Information Asymmetry (continued)

• Controlling estimation risk– Insider trading laws– Financial reporting

• Role of financial reporting is to convert inside information into outside, thereby reducing estimation risk

• Cannot eliminate all inside information. Why?

• Markets that “work well”– Low estimation risk, share prices as close to

fundamental value as is cost effective

A Graphical Illustration of Estimation Risk

4.7 Social Significance of Markets that Work Well

• In a capitalist economy, allocation of scarce capital to competing demands is accomplished by market prices– Firms with productive capital projects should

be rewarded with high share prices (low cost of capital) and vice versa

• Capital allocation is most efficient if share prices reflect fundamental value– Society is better off the closer are share prices

to fundamental value (i.e., if markets work well)

4.7 Social Significance of Markets that Work Well

(continued)• Social role of financial reporting

– To help markets work well• Maximize amount of publicly available

information• Subject to a cost-benefit constraint• Requires securities market efficiency

4.8 An Example of Full Disclosure

• Management Discussion and Analysis– Forward-looking orientation– Concept of information system is implicit

• Forward orientation and risk information increase main diagonal probabilities

– More relevant than historical cost-based financial statements. Less reliable?

– Reasonably consistent with decision theory

The End

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