Financial Accounting Theory SeventhEdition William R. Scott Chapter 4. Efficient Securities Markets

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1 Financial Accounting Theory SeventhEdition William R. Scott Chapter 4 Efficient Securities Markets

2 Chapter 4Efficient Securities Markets

3 4.2 Efficient Securities Markets Definition (Semi-strong form) At all times, market price of a security fully reflects all publicly available information about that security Characteristics of market efficiency Security prices do not reflect inside information Efficiency is a relative concept, defined relative to a stock ofpublicly available information Investing is a fair game no bargains Security prices fluctuate randomly over time Efficiency is a theoretical ideal The question of how close actual security markets are to this ideal is discussed in Chapter 6

4 4.3 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

5 4.4 The Informativenessof Price If market is fully efficient, share prices fully reflect all publicly available information. That is, prices are fully informativeabout value If share prices are fully informative, noonewould bother to gather information, since can t beat the market (fair game) If no one gathers information, share prices will not reflect allpublicly available information If share prices do not reflect all publicly available information, investors will gather information. Share price will quickly become fully informative Then, noone would bother to gather information, etc., etc. Hence a logical inconsistency >> Continued

6 The Informativenessof Price (continued) A way out of the logical inconsistency Noise trading Expected value of noise = 0 Share prices still efficient, but in an expected value sense Share prices are partially informative in presence of noise trading Share price may deviate from its efficient value due to noise trading Restores incentive of investors to gather information >> Continued

7 4.4 Something Does Not Sound Right Our story of informed investors making prices reflect all information resulting in efficient market One inconsistency 1. If market is efficient, then no one can earn excess return, and everyone earns their fair / normal return 2. So if no one earns excess return, why waste time and effort to analyze 3. So if no one spend time to collect and analyze the information, the market can no longer be efficient Sounds like chicken and egg problem or free rider problem (or your group with no leader, group of friends with no destination)

8 4.4 Something Does Not Sound Right Add one detail to the efficient market model Liquidity traders or noise traders They buy or sell for unpredictable or personal reasons which arenot market driven e.g. need money for hospital, hot tips, irrational reasons The liquidity and noise traders move prices, and informed traders can make excess return if they can decide the truth So informed traders will collect and analyze information again

9 4.4 Something Does Not Sound Right Companies also help by providing other information Management discussion and analysis (MD&A) in annual reports provides forward looking or more detailed information on company 1. Signaling by management of current company value and future performance Shares buyback / repurchase vs share issuance Buy back shares if current market price is undervalued Issue new shares if current market price is overvalued Change in dividend level Generally stable dividend level preferred Increase dividend level means management have confidence on future performance

10 4.5 A Capital Asset Pricing Model 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: >> Continued

11 Concept of a Security s Beta Beta measures the covariance of security s return j with market portfolio return M βj = Cov(j, M)/Var(M) Measures risk contributed by a security to a fully diversified portfolio Var(M) is the variance of the market portfolio (A standardization device so that betas from securities traded on different markets can be compared) 4-11

12 A Capital Asset Pricing Model (continued) 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 isbeta Thus P j,t-1 (i.e., current share price) must change in the denominator of Equation 4.2to keep(e jt ) unchanged

13 A Capital Asset Pricing Model (continued) Section (optional section) Critique of the CAPM CAPM assumes rational expectations Investors assumed to know beta In practice, investors do not know beta, so must estimate it, creating estimation risk CAPM assumes common knowledge Everyone knows that everyone knows beta, etc. This rules out sophisticated investors ability to take advantage of ordinary investors who have inferior knowledge of beta CAPM assumes no transactions costs and liquid markets CAPM assumes rational investors Despite these limitations, CAPM is a good place to start to appreciate the role of information in capital markets

14 4.6 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

15 4.6 Information Asymmetry Investor reaction to inside information Inside information another source of investor estimation risk 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., post-enron, post market meltdowns), or Yes, but pay less, to protect against estimation risk» Continued

16 4.6 Information Asymmetry Effect of estimation risk on share prices Efficient market price includes a discount for expected estimation risk (i.e., for expected losses at the hands of insider trading) In effect, investors demand a higher return Then, CAPM may understate cost of capital, since ignores estimation risk To some extent, estimation risk may be diversified away, but, since outside investors more likely to lose than gain from insider trading, some discount will remain» Continued

17 4.6 Information Asymmetry 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

18 A Graphical Illustration of EstimationRisk

19 4.7 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 fundamentalvalue (i.e., if markets work well)» Continued

20 4.7 Social Significance of Markets that Work Well 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

21 Exceptions to Efficient Markets Securities markets are efficient and everyone earns a fair return corresponding to their risk level? There are some exceptional situations Pockets of inefficiencies Illiquidity, e.g. private equity, venture capital Ability to collect and process information, e.g. real estate Rules and regulations, e.g. non-investment grade bonds Behavioral finance Asymmetric risk aversiveness of investors Investor biases

Financial Accounting Theory Seventh Edition William R. Scott. Chapter 6. The Measurement Approach to Decision Usefulness

Financial Accounting Theory Seventh Edition William R. Scott Chapter 6 The Measurement Approach to Decision Usefulness Chapter 6 The Measurement Approach to Decision Usefulness What Is the Measurement