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Chapter 4: Efficient Securities Markets
The Meaning of Efficiency: A market is efficient when security prices reflect all the available information. Under ideal conditions, information is free and investors have the opportunity to take advantage of available information and make rational decisions about securities prices in the market. Under non-ideal conditions, information is not free and investors have to do cost benefit analysis in order to decide how much information they acquire to make rational decisions. There are three types of efficient markets: weak form, semi-strong form, and strong form. We will discuss only semi-strong markets where all publicly available information about specific securities is reflected in securities price. When new information enters the securities market, prices will adjust quickly because investors will revise their prior beliefs. They will start selling and buying securities based on their new beliefs and this will cause changes in prices. It means that market prices are relative to publicly available information. Fluctuation in the market is expected due to the seasonal nature of business, or retirement of key employees, etc. The time series in which a particular securities price has random fluctuations, over a period of time, is called random walk.
How do Market prices properly reflect all available information? The notion that market prices reflect the information available is explained by decision theory. We know from previous chapters that rational, informed investors will demand all available information on securities. This theory does not guarantee that each investor’s decision will be same. Each investor’s decision will differ based on their prior beliefs as one or more inputs may differ. For example, investors may misidentify one or more probabilities required by Bayes’ theorem. If a specific number of investors interpret information properly they will make proper buy and sell decisions about securities. Other investors will follow their recommendations and the resulting prices will properly reflect all available information in a timely manner.
Capital Asset Pricing Model: The Capital Asset Pricing Model explains the relationship between the efficient market price, risk, and the expected rate of return on a security. The model answers the question, how do the investors find the rate of return on their investment? The rate of return on a share = (the price at the end of period + dividends paid) / price at the beginning of the period of a share. One is then subtracted from this value. We can also find the expected return on a share by using the expected price plus any dividends expected at the end of period. Thus, the CAPM relationship is: E (Rjt) = Rf + Bj [E (Rmt) – Rf] where Rf is rate of return on a risk free asset such as T-bills, Bj is the beta of security j, and Rmt is the return on the market portfolio for period t. This model takes risk factors into account, denoted by beta of the security j. There are two types of risk: systematic risk and non-systematic risk. Non-systematic risk is firm specific, which can be eliminated in a diversified portfolio and does not affect share price. Systematic risks are economy-wide, as all firms will be affected by these factors in turn affecting share price. Beta can also change over time if the risk of a firm or industry changes.
What is an Anomaly? Efficient securities market anomalies are investor behaviour that appears to contradict the theory of efficient markets. Rational single-person decision theory is called into question.
Prospective theory: An investor considering a risky investment (a prospect) will evaluate separate prospective gains or losses. The utility for gains is concave and risk averse while the utility for losses is convex, and “risk taking”. Investors weight payoff probabilities. This can lead to irrational behaviour, which turns anomalous if many act this way.
Behavioural finance: This is the study and documentation of abnormal security returns persisting for a length of time following an information event.
Post-announcement drift: When good news (GN) is reported, abnormal security returns drift upwards for at least sixty days. When bad news (BN) is reported, abnormal security returns drift downwards for at least sixty days.
The reason this occurs is the artifact of earnings expectation model used by researchers is up in the air. However, investors seem to underestimate the implications of current earnings for future earnings. As well, the correlation between GN in one quarter and the next is underestimated.
Market efficiency with respect to Financial Ratios: The market waits so details appear of the strategy to beat the market. Ou and Penman (OP) calculated 68 ratios for a number of firms. They saw that ratios predicted net income (NI) rising or falling in the next year. The best ratios were used as independent variables to estimate a multivariate regression model to predict changes in the next year NI. This is an anomaly for efficient securities market theory.
Market response to Accruals: NI is equal to operating cash flows (CF) plus net accruals. Net accrual includes items such as amortization expense or accounts payable. Efficient markets should react more strongly to one dollar of GN in NI if the dollar comes from operating CF rather than accruals, as they reverse.
Discussion: Explaining anomalies without leaving the efficient securities market theory was attempted with “risk”. But, rewards from risky stocks were not driving results. The firm size explains share returns in addition to beta. Results from OP reflect a permanent difference in the expected returns such as firm size or risk, rather than deviation from fundamental value. Transaction costs are another explanation for anomalies, as these costs limit the ability of investors to exploit post-announcement drift. So, unless we know what the cost of an investment strategy should be, we won’t know whether profits earned are anomalous.
Implications of Efficient Securities Markets for Financial Reporting: The first implication is accounting policies adopted by firms don’t affect their security prices, as long as policies are disclosed, have no differential CF effects, and information is given so readers can easily convert across policies. The second implication is that efficient securities markets go hand in hand with full disclosure. The next implication is that market efficiency implies financial statement information doesn’t need to be presented in an elementary form for everyone to understand. Naïve investors are price-protected as they can trust the efficient market to price securities. Finally, if accountants didn’t provide useful, cost-effective information, the usefulness of this function would decline to other information sources.
The Informativeness of Price: In efficient markets, the price of a security is fully informative; it fully reflects all available information of that security. Since information gathering is costly, and investors could not expect to beat the market, they will not be motivated to gather information. The logical inconsistency is this: if prices fully reflect available information, investors will not gather information; hence, prices will not fully reflect available information. The potential implication of this inconsistency is that financial statements may not be useful to investors.
The inconsistency is avoided because of the presence of liquidity traders or noise traders. These types of investors are irrational and make buy/sell decisions at random. As a result, share prices are only partially informative as they are now mispriced. Rational investors can gather more information about securities by carefully analyzing financial statements. Hence, financial statements are useful to investors. Their usefulness can be enhanced by MD&A’s and FOFI’s.
Information Asymmetry: Securities markets are subject to information asymmetry problems. Namely, it is likely that insiders know more than outsiders about the true quality of the firm, and the possibility exists that insiders will take advantage of this information to earn excess profits. This situation is an example of adverse selection. Investors are aware of this possibility and will lower the amounts they are willing to pay for shares. Thus, the securities markets do not work as well as they might. Financial reporting serves to reduce the adverse selection problem, thereby improving the operation of securities markets. Specifically, the full disclosure policy serves to expand the set of information that is publicly available. Also, timelines of reporting will reduce the ability of insiders to profit from their information advantage.
Social Significance of Properly Working Securities Markets: There is a social significance of properly working securities markets. If information asymmetry exists, firms with high-quality investment projects will not receive a high price for their securities, and the market is not working as well as it should. However, penalties against insider trading and the requirement of full disclosure are mechanisms by which the smooth operation of securities markets is maintained.
Full Disclosure: Efficiency in the securities market is based upon the underlying principle of publicly available information. While a company’s financial statements reveal to us valuable information about their current financial standings, investors often desire to know more about a particular company in order to make informed investment decisions. For this reason, many companies follow a policy of full disclosure through the use of accounting standards such as Management Discussion and Analysis (MD&A) and Future-Oriented Financial Information (FOFI).
In accordance with Statement 5.10 and the Ontario Securities Commission (OSC), MD&A is required for large firms (i.e. those firms with shareholder’s equity and revenues in excess of $10 million), but is optional for all others. MD&A focuses on the decision usefulness approach, attempting to provide users with relevant information to assess the future prospects of a firm. The MD&A disclosure requires discussions on current operations and financial conditions, risks and uncertainties, financial instruments, known trends, and any other information that is not clearly presented in the financial statements, but which can be obtained “without undue effort or expense” to the firm. MD&A is separate from the financial statements, however, its purpose is much the same – to provide investors with useful information that allows them to assess the future prospects of a firm.
FOFI is another financial forecasting standard that aims to further expand the information available to investors. Under Section 4250 of the CICA Handbook, FOFI is not required. However, many firms choose to engage in this standard to enhance their reputation for full and timely disclosure to their users, and in the case of smaller corporations, to reveal more information about themselves to the public. It is suggested that FOFI not exceed a period of approximately one year, for beyond such a time the information may not be reasonably estimated. In order to maximize the usefulness of FOFI, it is formatted in such a way that is commonly known and understood by users. Providing a linkage between past and future results, FOFI allows for comparability over time and provides disclosures that are important and potentially useful to investors.
Full disclosure through the use of MD&A and FOFI standards allow companies to communicate information to the public beyond what is presented in their conventional financial statements. Investors can learn a lot about a firm based on the information that they disclose and to what extent they disclose it.
CHAPTER 4 QUESTIONS AND SOLUTIONS
Q: 1 What are the three forms of efficient market?
Solution: Weak market, Semi-strong market, and Strong market.
Q: 2 What is a Semi-Strong Market?
Solution: Semi-Strong Market is a market where all public available information reflects securities price.
Q: 3 Are all information costs free under ideal condition?
Solution: yes, under ideal conditions, all the investors know all information since the state realization is publicly observable and objective probability.
Q: 4 Are all information cost free under non-ideal conditions and how do investors evaluate if they require more information or not?
Solution: Under non-ideal conditions, information is not cost free because each investor has his/her own subjective estimates and requires different sets of information in order to make decisions.
Investors do cost benefit analysis and determine if they will acquire more information. If the cost of information acquired out weight the benefits obtained by that information then investor does not spend to acquire more information.
Q: 5 Do investors have same decision with new available information?
Solution: No, investors do not have same decision with new available information. As we know the decision theory does not guarantee that investors will have same decision. Investors new decision will differ based on prior beliefs and might have one or more inputs that are different. For example, investor may misidentify one or more probabilities required by Bayes’ theorem.
Q: 6 What is a Capital Asset Pricing Model?
Solution: Capital Asset Pricing Model explains the relationship between market price of security, its risk, and the expected rate of return on a security. CAPM relationship is shown by following equation: E (Rjt) = Rf + Bj [E (Rmt) – Rf] where Rf is rate of return on risk free asset such as T-bills, Bj is the beta of security j, and Rmt is the return on the market portfolio for period t. CAPM relationship is based on some assumption such as investors are risk adverse, all the information is publicly known and available.
Q: 7 What are the two types of risk faced by investors? Explain?
Solution: Two types of risk are market and non-market risk.
Non-market risks are firm specific and these are related to specific firm and its stock price. Non-market risk can be eliminated by diversification.
Market risks are economy wide risks, which cannot be eliminated, and this will affect all firms. For example, September 11, 2001 was market risk and this affected all the firms and stock prices decreased drastically.
Q: 8 Are fully informative share prices in the best interest of the accounting profession? Why or Why not.
Solution: Fully informative share prices are not in the best interest of the accounting profession. If securities prices were fully informative, investors would be able to make rational buy/sell decisions based solely on the price of securities. They would not require any additional sources of information. Hence, financial statements, being an additional source of information, would become useless, and the demand for accountants would diminish.
Q: 9 Describe the “lemons” phenomenon with respect to securities markets.
Solution: Because of adverse selection, investors would recognize that the securities market is not a level playing field, and would either withdraw from the market, or lower the amount they are willing to pay for any security. Thus, firms with high quality investment projects will not receive a high price for their securities.