THE EFFICIENT MARKETS HYPOTHESIS AND CAPITAL ASSET PRICING MODEL

The Efficient Markets Hypothesis Jensen (1978) defines an efficient market as follows: –A market is efficient with respect to information set  t if it is impossible to make economics profits by trading on the basis of information set  t. Risk-adjusted rate of return. On average. Economic profits are net of all costs.

The Efficient Markets Hypothesis (Cont’d) 3 broad categories: –Weak form Past security prices and/or past trading volume. –Semistrong form All published information –Strong form All information

The Efficient Markets Hypothesis and the Previous Literature A common hypothesis in the early 1960s: corporate accounting reports are the only source of information on the corporation. –Managers are able to report the result they want and mislead stock market –Stock market cannot discriminate between efficient and less efficient corporations –All corporations should be required to use the same accounting procedures

The Efficient Markets Hypothesis and the Previous Literature Hypothesis that corporate accounting reports are the only source of information on the corporation: –Led to the criticisms of the calculation of accounting earnings –Earnings are not calculated consistently –Earnings are meaningless numbers –Stock prices based on them could not be useful signals for the allocation of resources

The Efficient Markets Hypothesis and the Previous Literature (Cont’d) Efficient Market Hypothesis: –Sole source hypothesis is unlikely to be descriptive. –The market is not systematically misled by accounting earnings. –Earnings can be useful –Competition for information: obtain information for many sources.

The Efficient Markets Hypothesis and the Previous Literature (Cont’d) The implications of efficient market contradict the hypothesis that accounting reports are the sole source of information and its implication These contradictions led to researchers addressing two questions: –Do changes in accounting methods and their earnings effects systematically mislead the stock market? –Are accounting earnings associated with stock prices or changes in stock prices? Requires a model that shows how accounting earnings are related to stock prices –CAPM

The Capital Asset Pricing Model Original CAPM model assumption: –The only parameters: E(r i ) and  2 (r i ) –Markets are perfect –Investors are rational and risk averse –Investors assume that other individuals also act rationally –Homogeneous expectation. –Riskless asset and all individuals can borrow and lend at riskless rate.

The Capital Asset Pricing Model CAPM: –Risk measure is Rewritten in terms of prices:

The Capital Asset Pricing Model Under the multiperiod version of the CAPM, the market value of the firm is the discounted expected future cash flows.

The CAPM and Accounting Numbers The Potential for Information in Accounting Numbers –Accounting earnings can be associated with cash flows. –Accounting number can supply information on other variable in CAPM: Expected rate of return. Expected rate of return depends on the risk of the asset That risk is likely to be empirically associated with accounting numbers

The CAPM and Accounting Numbers (Cont’d) The Specified Relation Between Earnings and Stock Prices –Concentrate on the relation between changes in earnings and changes in stock prices around earnings announcement. –Relation between unexpected earnings and the abnormal rate of return: Ball and Brown (1968)

The CAPM and Accounting Numbers (Cont’d) The Specified Relation Between Earnings and Stock Prices (Cont’d) –Unexpected accounting earnings that are solely the result of accounting procedures will not be associated with the abnormal rate of return, unless they are also related to unexpected changes in risk or cash flows.

The CAPM and Accounting Numbers (Cont’d) The Specified Relation Between Earnings and Stock Prices (Cont’d) –Empirical tests of the relation between abnormal rates of return and unexpected earnings require estimates of normal rates of return and expected earnings. Expected earnings: Ch. 6 Normal rates of return: market model

The CAPM and Accounting Numbers (Cont’d) The Market Model –Normal rates of return are typically determined using the market model r i,t =  i +  i r m,t +  i,t  i,t is abnormal rate of return

Information Asymmetry Information asymmetry: some parties to business transactions may have an information advantage over others Two major types of information asymmetry –Adverse selection –Moral hazard

The Lemons Problem

Akerlof (1970)  used car market

The Lemons Problem Securities markets are subject to information asymmetry problems Can lead to the breakdown in the functioning of the capital market Investors can’t differentiate between good ideas and bad ideas. –Value all ideas as average. Full and timely disclosure will reduce this problem, thereby improving the working of capital markets –External audits