Chapter 4 Efficient Securities Markets

Organization of This Chapter

Securities Market Efficiency

What does securities market efficiency (semistrong form) mean?

How about strong form efficiency? Which one is the commonly used assumption?
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Securities Market Efficiency and Rational Investors

Chapter 3: rational investors

expected utility maximizing decisions continuous process of belief revision: update their state probabilities as new information comes in envisage a large number of rational investors interacting in a security market their collective decisions result in market price

A way to think about market efficiency:

Market Efficiency: Beavers Football Forecasting Example

1966
Total forecasters (incl. consensus) Total forecasts made per year Rank of consensus Rank of best forecasters: J. Carmichael (1966) D. Nightingale (1966) 1 (tie) 1 (tie) 8 11 16 5 15 180 1 (tie)

1967
15 220 2

1968
16 219 2

A. Biondo (1967)
H. Duck (1968)

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8

1
10

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Implications of Market Efficiency for Financial Reporting

Beaver (1973)

A Capital Asset Pricing Model (CAPM)

CAPM: E(Rjt) = Rf(1 - j) + jE(RMt)

Expressed in a form consistent with the market model: Rjt = j + jRMt + jt Another form: E(Rjt) = Rf + j[E(RMt) - Rf ] where market premium is E(RMt) - Rf Market sets share price so that expected return E(Rjt), i.e., firms cost of capital, is given by right side of equation Note that only firm-specific component is j
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How is expected return defined?

A Capital Asset Pricing Model (CAPM) (cont.)

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 E(Rjt) unchanged
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A Capital Asset Pricing Model (CAPM) (cont.)

CAPM assumes rational expectations

Investors know beta

In practice, investors do not know beta, so must estimate it

This is an example of estimation risk

Information Asymmetry

The fundamental value of a share

The value of a firms share on an efficient market if all information about the firm is publicly available, i.e., no inside information Information about the firm that is not publicly available

Inside information

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Information Asymmetry (cont.)

Investor reaction to inside information

Inside information is another source of investor estimation risk Adverse selection - the lemons problem (Akerlof (1970)) Would you buy a used car from someone you do not know? If so, how much would you pay? Would you buy a share in the presence of inside information? No, withdraw from market, market collapses (e.g., postEnron) Yes, but pay less, to protect against estimation risk

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Information Asymmetry (cont.)

Effect of estimation risk on share prices

Efficient market price includes a discount for estimation risk, i.e., investors demand a higher return CAPM understates cost of capital, since ignores estimation risk

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Information Asymmetry (cont.)

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? Definition of markets that work well

Low estimation risk, share prices as close to fundamental value as is cost effective

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Role of Financial Reporting in an Efficient Market to Reduce Estimation Risk

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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)
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Social Significance of Markets that Work Well (cont.)

Social role of financial reporting To help markets work well

Maximize amount of publicly available information Subject to a cost-benefit constraint

Social role of financial reporting is enhanced if securities markets are efficient Then, market fully uses financial accounting information
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An Example of Full Disclosure MD & A

Management Discussion and Analysis (MD & A) 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
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