Chapter 4 Efficient Securities Markets Copyright 2009 by

4. 5 Share Price on an Efficient Market • CAPM E(Rjt) = Rf(1 - βj) + βj. E(RMt) Market sets share price so that expected return E(Rjt) (i. e. , firm’s cost of capital) is given by right side of equation Note that only firm-specific component is ßj – How is expected return defined? See Equation (4. 2) in text: Copyright © 2009 by Pearson Education Canada 3

4. 2 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 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 Copyright © 2009 by Pearson Education Canada 5

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 (Ejt) unchanged Copyright © 2009 by Pearson Education Canada 6

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 7

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 8

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 9

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 Copyright © 2009 by Pearson Education Canada 10

4. 6 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 11

4. 6 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 12

4. 6 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 13

4. 6 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 14

A Graphical Illustration of Estimation Risk Copyright © 2009 by Pearson Education Canada 15

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 fundamental value (i. e. , if markets work well) » Copyright © 2009 by Pearson Education Canada Continued 16

4. 7 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 17

4. 8 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 Copyright © 2009 by Pearson Education Canada 18