Copyright © 2009 by Pearson Education Canada Chapter 4 Efficient Securities Markets

Copyright © 2009 by Pearson Education Canada Chapter 4 Efficient Securities Markets

Copyright © 2009 by Pearson Education Canada Share Price on an Efficient Market CAPM E(R jt ) = R f (1 - β j ) + β j E(R Mt ) Market sets share price so that expected return E(R jt ) (i.e., firm’s cost of capital) is given by right side of equation Note that only firm-specific component is ß j –How is expected return defined? See Equation (4.2) in text:

Copyright © 2009 by Pearson Education Canada Efficient Securities Markets 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

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada How Does Accounting Information Affect Share Price? In Equation (4.2), accounting information affects the numerator E(P jt + D jt ) E(R jt ) does not change, since only firm specific component in CAPM is beta Thus P j,t-1 (i.e., current share price) must change in the denominator of Equation 4.2 to keep (E jt ) unchanged

Copyright © 2009 by Pearson Education Canada The Informativeness of Share 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

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada 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 »Continued

Copyright © 2009 by Pearson Education Canada 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 »Continued

Copyright © 2009 by Pearson Education Canada 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? »Continued

Copyright © 2009 by Pearson Education Canada 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 »Continued

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada A Graphical Illustration of Estimation Risk

Copyright © 2009 by Pearson Education Canada 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) »Continued

Copyright © 2009 by Pearson Education Canada 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

Copyright © 2009 by Pearson Education Canada 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