Chapter 4

Efficient Securities Markets

Summary & Quiz

Chapter 4

Efficient Securities Markets

4.1Overview

Market prices reflect publicly available information that is gathered from many sources and interpreted in many different ways. The quality of information gathered has an effect on the price of the security. By providing relevant, reliable, timely, and cost-effective information, accountants can help to overcome some of the challenges of achieving an “efficient securities market”.

4.2Efficient Securities Markets

4.2.1The Meaning of Efficiency

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

The above definition is referred to as the semi-strong form of the market where the prices of securities reflect all public information at all times. Challenges to this definition that all contribute to the alteration of a security’s price include information gathered outside of public reach, estimations, and differing sources of information. Informing investors of market conditions helps them to make responsible decisions regarding securities. When enough investors behave in an informed manner, the market is said to be “efficient”. Random Walk is a characteristic of an efficient securities market as it represents the tendency for a security’s price to fluctuate over time.

4.2.2How Do Market Prices Properly Reflect All Available Information

Regardless of differing sources and interpretations of information, the market price of a security is considered to properly reflect all available information. Over time, and with enough investors, “errors” in interpreting data tend to cancel each other out, resulting in an overall “market price”. The idea that the market is on average unbiased and that all available information is used to determine market prices is referred to as “rational expectations”.

4.3 A Capital Asset Pricing Model

The Sharpe-Lintner Capital Asset Pricing Model (CAPM) is a model designed to determine what the price of a security “should” be given an efficient securities market. It is defined as:

Rjf = Pjt + Djt – Pj,t-1 = Pjt + Djt –1

Pj, t-1 Pj, t-1

Where:

Rjt= rate of return on the shares of firm j for time period t.

Pjt= market price of firm j’s shares at the end of period t.

Djt= dividends paid by firm j during period t.

Pj, t-1= market price of firm j’s shares at the beginning of period t.

Two variations of this formula that predict what the expected return of the security will be are:

E(Rjt) = E(Pjt + Djt) – 1E(Rjt) = Rf(1 – βj) + βjE(RMt)

Pj, t-1

Where:

βj= the Beta of share j (for a definition of Beta see page 66 of text)

RMt= the return on the market portfolio for period t.

This means that after the expected share price is determined, the current share price would be adjusted according to the “news” it receives about that security. If an expected return is determined and bad news is received, the share price will have to change to maintain the expected return.

For example, suppose you wanted to calculate the share price at the end of a period. First, use the CAPM equation and calculate the expected return. This value is what is supposed to be held constant. Second, calculate the price that the shares would have to be at the end of the year to support that expected return. This would be the price of the shares assuming that the market was stable. If an investor received bad news about the security, the share price would have to change in order to keep the expected return at the value calculated before. The assumption in this example is that Beta would not have changed. If Beta had changed, investors’ expectations would have also changed.

The CAPM can be used to determine what the rational investor would do in the market. If an investor’s expected return falls below the CAPM value then s/he would sell his/her shares. Enough investors would react in this way until the price of the security had dropped enough to be consistent with the price calculated by the CAPM (as above). The level of Beta a security has determines what the price of that security should be.

4.4 Is Beta Dead?

Beta is not “dead”, but it can change over time, which may conflict with the CAPM.

Accounting information does not change the response of security prices any more than the Efficient Securities Market theory predicts.

Investors may face two types of uncertainty that will affect the price of a security. Exogenous uncertainty is a result of market-wide uncertainty, while endogenous uncertainty is due to the actions and reactions of investors.

4.5 Efficient Securities Market Anomalies

4.5.1What Is An Anomaly?

Efficient Securities Market Anomalies – Instances of investor behaviour that appear to contradict the theory of efficient securities markets.

Anomalies are events that alter the price of a security that cannot be explained by theory. Abnormal trends in trading surrounding certain days in a month are considered to be an anomaly.

4.5.2Prospect Theory And Behavioural Finance

Because investors tend to inaccurately estimate the return on potential investments, they may act irrationally and stay out of the market for fear of loss, even when the prospective security should theoretically give them a gain. Reactions to good news and bad news are often inconsistent with what they “should” be.

If enough investors behave in this manner, the stock market may act in an anomalous behaviour and may result in abnormal security returns. Behavioural Finance is the term given to the study of this anomalous behaviour.

4.5.3Post-Announcement Drift

This is the tendency for security returns to drift abnormally upward, or downward, for 60 days or more following the good news, or bad news, earnings announcement. This would not occur in a fully efficient market.

4.5.4Market Efficiency With Respect To Financial Ratios

Investors may be able to “beat” the market by using balance sheet information properly. In an efficient market this should never be the case. This phenomenon is arguably explained by the higher risk (higher beta) of the securities associated with the firms studied.

4.5.5Market Response To Accruals

Since all accruals reverse in the future, it is thought that the market should respond more strongly to a dollar earned through operating cash flow, rather than the dollar that was set aside as an accrual. One study found that the market responded to good and bad news, but did not take into account the difference in money in the cash-accrual situation.

4.5.6Conclusions About Securities Market Efficiency

Because there has not been a better theory to explain the movements of the market, Efficient Securities Market theory is still accepted. Due to this acceptance, accountants are able to understand the needs investors have in making their investment decisions and are therefore able to prepare useful financial statements to satisfy this need.

4.6 Implications Of Efficient Securities Markets For Financial Reporting

4.6.1Implications

There are four main points implied by the Efficient Securities Market theory that relate to financial reporting:

  • As long as a firm’s accounting policy does not have a differential cash flow effect, the policy is disclosed, and the reader is able to convert the information to be compared to other companies’ policies, then security prices are not affected by the choice of policy.
  • Information should always be fully disclosed, provided the costs of disclosing this information do not exceed the benefits.
  • Financial reports should be prepared with the assumption that the reader is not a naïve investor. Naïve investors are “price-protected” by the shifts in the market price and should therefore, not be catered to.
  • If accountants do not supply useful, cost-effective, and timely information then their function of providing information may be taken over by other sources, making an accountant’s function less important.

Above all, information, including notes about the accounting policies used by the firm, must be fully disclosed. Footnotes, management discussion and analysis, notes to the financial statements, and supplemental disclosure notes are all useful tools.

4.7 The Informativeness of Price

4.7.1A Logical Inconsistency

Noise traders buy and sell securities in unpredictable fashions. Because their reasons for making decisions vary, security prices may not be what they “should” be. Properly using financial statements to analyze information may enable the informed investor to buy and sell securities at a profit.

Firms that feel that their securities may be undervalued may gain from disclosing more information than they normally would have. Disclosing this information may lead the informed investor to drive up the price of the security.

4.8 Information Asymmetry

4.8.1The Concept Of Information Asymmetry

Information Asymmetry – when one type of participant in the market will know something about the asset being traded that the other type does not.

Inside information is a result of not living in an ideal environment. When this occurs, the problem of adverse selection may occur. Because of this, investors will lower the bid they would be willing to make on that security. This lowered bid would ensure that they would not lose as much as they would have if they had not been trading against a person who had more information than them.

Timely, fully disclosed, financial reporting reduces the adverse selection problem as it attempts to complete the level of information available to the public.

4.9 The Social Significance of Properly Working Securities Markets

As a result of providing useful financial reports to users, society benefits as a whole. Useful statements reduce the effects of adverse selection, which increases the confidence of investors and the number that are willing to participate in the market. With more investors participating in the market, there is a greater tendency toward achieving an efficient securities market.

4.10 Examples of Full Disclosure

4.10.1Introduction

Firms that voluntarily disclose more information than they are required are thought of as being more confident in their future positions. This added confidence might increase chances of investors choosing to buy their securities.

4.10.2Management Discussion And Analysis

In this section of the report, management discusses its current financial statements, placing emphasis on their prospects for the future.

4.10.3Future-Orientated Financial Information

FOFI is relevant to financial users as it involves a direct prediction of next year’s operations. It mentions forecasts and projections for the future—plans of the firm, both with the information it has available and with assumed information.

In conclusion, Efficient Market Theory is designed to predict what a security’s price should be, properly reflecting all publicly known information about that security. The key point to note is that not all information is publicly known. Insider trading and market anomalies alter the prices of securities. By providing useful financial statements, accountants can help the public to overcome some of the problems caused by these random acts.

Chapter 4

Efficient Securities Markets Quiz

(Without Answers)

Multiple Choice (4 minutes)

1. An ex post return is:

  1. The calculation of a return realized during the period that had just ended.
  2. The calculation of a return before the period has started.
  3. The calculation of a return in an efficient securities market.
  4. None of the above.
  1. Post announcement drift is:
  1. The upward shift of stock prices for at least 60 days following the company’s earnings announcement for the period.
  2. The downward shift of stock prices for at least 60 days following the company’s earnings announcement for the period.
  3. The drifting of the demand of a stock once the earnings announcement has been made.
  4. Both a & b
  1. A noise trader is:
  1. A trader that starts rumours about stocks to profit off the speculation that has resulted.
  2. Also called a liquidity trader.
  3. A person who buys or sells securities for a variety of unpredictable reasons.
  4. Both b & c
  1. A method, used by a firm, of credibly communicating to the market the value of high-quality investment projects with the intent of raising that firm’s security price is known as:
  1. Inside Information
  2. Timeliness
  3. Signalling
  4. Full Disclosure
  5. None of the above
  1. Which of the following statements regarding Information Asymmetry is false:
  1. Information Asymmetry hampers the proper operation of markets.
  2. Two types of Information Asymmetry are adverse selection and moral hazard.
  3. Information Asymmetry can be combated in market environments through full disclosure.
  4. Information Asymmetry alone may cause a market to collapse in extreme cases.
  5. None of the above.

Short Answer Questions

1. Define an Efficient Securities Market. (2 minutes)

2. What is the Sharpe-Lintner CAPM used for? (2 minutes)

3. What are the 4 vehicles of communication that make accounting information valuable?

(2 minutes)

Long Answer Questions

1. Using the information provided, calculate the share price at the beginning of the period:

(5 minutes)

CAPM= E(Rjt) = Rf (1-Bj) + BjE(RMt)

Net rate of return = E(Ejt) = (E(Pjt + Djt)/Pj, t-1)–1

Where: E(Rjt) = expected return for the security

Rf = risk free rate

βj = beta for firm j

E(RMt) = expected market rate of return in the current period

Pjt = price of the security at the end of period t

Djt = dividend paid by the firm during period t

Pj, t-1 = security price at the beginning of period t

Assume: Risk Free Rate = 10%

Expected Market Return = 14%

Beta of firm j = .70

Dividend of firm j = 1.24

Share price at the end of the period = $23.00

2. With reference to the article “TSE Demands Accurate Data From Cinar Corp.”, included in the Chapter 4 class notes, explain why full disclosure is an important factor in an efficient securities market. Relate your answer to Cinar Corp. and its shareholders as examples. (15 minutes).

Chapter 4

Efficient Securities Markets Quiz

(With Answers)

Multiple Choice (4 minutes)

1. An ex post return is:

  1. The calculation of a return realized during the period that had just ended.
  2. The calculation of a return before the period has started.
  3. The calculation of a return in an efficient securities market.
  4. None of the above.

2. Post announcement drift is:

a. The upward shift of stock prices for at least 60 days following the company’s earnings announcement for the period.

  1. The downward shift of stock prices for at least 60 days following the company’s earnings announcement for the period.
  2. The drifting of the demand of a stock once the earnings announcement has been made.
  3. Both a & b

3. A noise trader is:

  1. A trader who starts rumours about stocks to profit off the speculation that has resulted.
  2. Also called a liquidity trader.
  3. A person who buys or sells securities for a variety of unpredictable reasons.
  4. Both b & c

4. A method, used by a firm, of credibly communicating to the market the value of high-quality investment projects with the intent of raising that firm’s security price is known as:

  1. Inside Information
  2. Timeliness
  3. Signalling
  4. Full Disclosure
  5. None of the above

5. Which of the following statements regarding Information Asymmetry is false:

a. Information Asymmetry hampers the proper operation of markets.

b. Two types of Information Asymmetry are adverse selection and moral hazard.

  1. Information Asymmetry can be combated in market environments through full disclosure.
  2. Information Asymmetry alone may cause a market to collapse in extreme cases.
  3. None of the above.

Short Answer Questions

1. Define an Efficient Securities Market. (2 minutes)

A market where the prices of securities traded properly reflects all publicly known information about those securities at all times.

2. What is the Sharpe-Lintner CAPM used for? (2 minutes)

It is used to formalize the relationship between the efficient market price of a security, its risk, and the expected rate of return on that security.

3. What are the 4 vehicles of communication that make accounting information valuable?

(2 minutes)

The four elements are:

- Relevance

- Reliability

- Timeliness

- Cost-effectiveness

Long Answer Questions

1. Using the information provided, calculate the share price at the beginning of the period:

(5 minutes)

CAPM= E(Rjt) = Rf (1-βj) + βjE(RMt)

Net rate of return = E(Ejt) = (E(Pjt + Djt)/Pj, t-1)–1

Where: E(Rjt) = expected return for the security

Rf = risk free rate

βj = beta for firm j

E(RMt) = expected market rate of return in the current period

Pjt = price of the security at the end of period t

Djt = dividend paid by the firm during period t

Pj, t-1 = security price at the beginning of period t

Assume: Risk Free Rate = 10%

Expected Market Return = 14%

Beta of firm j = .70

Dividend of firm j = 1.24

Share price at the end of the period = $23.00

Expected return = Risk-free rate(1 –Beta) + Beta(Expected market rate of return)

= .10(1.00 – .70) + .70(.14)

= .10(.30) + .098

= .03 + .098

= .128 ie. 12.8%

Using: Net rate of return = E(Rjt) = [E(Pjt + Djt) / Pj, t-1] –1

Solve for Pj, t-1:

.128 = [(23.00 + 1.24) / Pj, t-1] –1

1.128 = 24.24 / Pj, t-1

Pj, t-1 = 24.24 / 1.128

Pj, t-1 = $21.49

2. With reference to the article “TSE Demands Accurate Data From Cinar Corp.”, included in the Chapter 4 class notes, explain why full disclosure is an important factor in an efficient securities market. Relate your answer to Cinar Corp. and its shareholders as examples. (15 minutes).

- Efficient securities markets go hand in hand with full disclosure

- If a firm’s management possesses relevant information about the firm and if this information can be disclosed at little or no cost, management should then disclose this information on a timely basis unless it is certain that the information is already known to investors from other sources

- Management should develop and report information about the firm as long as the benefits to investors exceed the costs

- Two reasons for this:

- FIRST: Market efficiency implies that investors will use all available, relevant information as they strive to improve their predictions of future returns, so that additional information will not be “wasted”

- SECOND: The more information a firm publishes about itself, the more information is publicly available about that firm

- CONSEQUENTLY: Investors confidence in the securities market is enhanced

As in the case of Cinar Corp.: