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Chapter 3
The Financial Information Marketplace
Learning Objectives
You will be able to identify the most important sources of information about
the money and capital markets and the financial system.
You will discover why the efficient distribution of information within the
financial system is so important and what can happen when relevant financial
information is not readily available to all market participants.
You will understand how any individual or institution active in financial
marketplace can keep track of the prices of financial assets, interest rates, and
other financial variables.
In an appendix to the chapter you will learn about the Flow of Funds Accounts
of the United States and discover what is meant by social accounting.
Chapter Outline
3.1. Introduction: The Importance of Information in the Financial
Marketplace
3.2. The Great Debate over Efficient Markets and Asymmetric Information
3.2.1. The Efficient Markets Hypothesis (EMH)
3.2.1.1. What Is an Efficient Market?
3.2.1.2. Different Forms of the EMH
3.2.1.3. Insiders and Insider Trading
3.2.1.4. What Is Insider Trading?
3.2.1.5. When Is Insider Trading Legal or Illegal?
3.2.2. The Asymmetric Information Hypothesis (AIH)
3.2.3. Problems Asymmetries Can Create: Lemons and Plums
3.2.4. Problems Asymmetries Can Create: Adverse Selection
3.2.5. Problems Asymmetries Can Create: Moral Hazard
3.2.6. Asymmetry, Efficiency, and Real-World Markets
3.2.7. Informational Asymmetries and The Law
3.3. Debts Security Prices and Yields: Sources of Information
3.3.1. Bonds and Notes
3.3.2. Bid and Asked Prices and Pricing Information
3.4. Stock Prices and Dividend Yields: Sources of Information
3.4.1. Price and Yield Information
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2. Can you explain why financial information that is accurate and reliable is of
great significance to government policymakers and regulators within the
financial system?
Answer: Government policymakers need information to ensure the smooth
functioning of the financial markets, to make sufficient credit available to support
business and commerce, to promote full employment, price stability, satisfactory
economic growth, and a satisfactory balance of payments position for the nation.
Because the Federal Reserve makes decisions daily to enter the market for the nation
to buy or sell, so as to influence the availability of credit and interest rates, data on
security prices and yields as well as economic conditions are necessary.
3. Carefully explain what is meant by the term efficient market. Are there
different levels of market efficiency? What are these levels?
Answer: An efficient market exists when all information that is relevant is used to
value or price financial assets. When a market is efficient, no investor can earn excess
returns using the information available to all. Instead, investors should expect to earn
an ordinary or normal return for the degree of risk they take on.
There are three forms of market efficiency. The weak form of the EMH says
that current prices reflect all past prices and trading volume. No single investor can
earn excess profits from using this information. The semi-strong form of the EMH
says that all publicly available information will be reflected in the current price, so no
investor can earn excess profits using this information. The strong form of the EMH
says that all public and private information is relevant to valuing financial assets.
Therefore an investor with private information (insider) can earn excess profits.
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Chapter 03 - The Financial Information Marketplace
Price of S'
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On the other hand, rent control in certain areas, such as New York City, leads
to permanent under-pricing of real estate assets for the lucky tenants who have been
the incumbent tenants. (The Boston Globe, April 28, 1997, p. A1.)
6. As you look at the real world around you, do you see examples of what seem to
be efficient markets? Can you detect any real-world examples of what seem to be
informational asymmetries? How did you identify these market situations?
Answer: Waiting lines at the customs at the airport provide a good example of an
efficient market whenever a short line is formed by chance, people will start to
move toward that line, and it doesnt take long to see that that line develops to be as
long as the other lines.
Informational asymmetries exist in the insurance industry. For example,
buyers of health insurance know more about their own health than the insurance
companies. Since less healthy people are more likely to buy health insurance, the
insurance companies, being aware of this, will price health insurance policies to
reflect the cost of a less-healthy-than-average person. As a result, people with average
or better health are at disadvantage when they buy health insurance. Such situations
will occur in real life when one party in a transaction knows more than the other party.
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7. What steps have been taken recently to promote greater accuracy and
reliability of information concerning the financial marketplace and the valuation
of individual assets?
Answer: In the fall of 2000 the U.S. Securities and Exchange Commission passed
Regulation FD (for Fair Disclosure). This required companies to disclose material
financial information broadly rather than only to selected viewers (such as stock
brokers or security dealers). This supposedly gives all possible investors roughly
equal access to market moving information. Even more recently a settlement between
the New York Attorney Generals Office and major brokerage companies in 2003
restricted the exchange of privileged information between security brokers and their
wealthiest clients who often pay large brokerage commissions and expect special
treatment in return. At about the same time the SEC moved to block mutual funds
from releasing inside information about the funds portfolio strategies to hedge funds
and other large investors. Rules such as these help to protect the public by giving
them more equal access to pertinent information as an aid to sound financial decision
making.
While the government regulations and controls recently put in place to
mitigate the damaging effects of asymmetric information may be helpful in improving
the efficiency of the financial markets, many observers think we have a long way to
go in solving asymmetric information problems. They point, for example, to the case
of Enron Corporation, a huge energy firm that filed for bankruptcy in 2001 and whose
alleged insider dealings and questionable accounting practices cost investors billions
in stock market losses and destroyed the retirement savings of many Enron
employees. The accounting practices of major corporations need a closer look today
to make sure that capital-market investors are getting the full amount of reliable and
relevant information they need to make rational buy-sell decisions. The Sarbanes-
Oxley Accounting Practices Act of 2002 makes chief executive officers (CEOs) and
chief financial officers (CFOs) of public companies responsible when their firms
dispense inaccurate or misleading information about the financial condition of the
businesses they manage. Sarbanes-Oxley represents a step toward a more information-
rich and information-reliable financial marketplace, but it is only a step in what is still
a long road to travel.
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Answer: Two of the most respected sources of information on major security issues
and issuers are Moodys Investor Service and Standard & Poors Corporation.
Moodys offers research studies focusing upon the performance and financial
condition of thousands of businesses, financial institutions, and governmental
authorities in both domestic and foreign markets, provides opinions on economic and
credit trends, etc. Standard & Poors Corporation provides similar services, including
credit research, credit ratings for securities offered in financial marketplace, and
investment portfolio recommendations, etc.
10. Suppose you were planning to take a job with a particular company. What
would you want to know about the company and where could you find that
information?
Answer: You need to know how well the company is performing within the industry,
and you may also want to know if that particular industry is still growing or mature.
Financial newspapers such as Wall Street Journal, Fortune Magazine, and Forbes are
good sources of information. You should also visit the career planning and placement
center at your school to obtain company brochures for the most up-to-date
information. Visit the company's website too!
11. If you wanted to gather information about the state of the U.S. economy,
which information sources would likely be most helpful to you?
Answer:
Board of Governors of the Federal Reserve System - http://www.federalreserve.gov
U.S. Government Printing Office - published statistical information
Project sponsored by the University of California - http://www.access.gpo.gov
The Comptroller of the Currency - http://www.occ.treas.gov/
Federal Reserve Bank of New York - http://www.ny.frb.org/
The International Monetary Fund - http://www.imf.org/
12. Where could you go to gather information about the global economy?
Answer: Visit http://www.economist.com for worldwide economic data. Visit
http://www.finance.yahoo.com/ and http://www.cnnfn.com for additional links to
many different countries.
13. Why would information about the global and domestic economies be of
assistance to investors in stocks, bonds, and other financial assets?
Answer: Because a number of different sources provide market participants with
information on developments in the economy, prevailing trends in the money and
capital markets, and actions by the government that may affect economic and
financial conditions worldwide. Today, all financial markets have been connected
around the world.
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A-2. Compare and contrast the Flow of Funds Accounts with the National
Income and Product Accounts. What types of information does each system of
accounts provide that could be useful for making financial decisions?
Answer: National Income Accounts (NIA), compiled and issued quarterly by the U.S.
Department of Commerce, present data on the nations production, income flows,
investment spending, consumption, and total savings. NIA provides extensive
information on the level and growth of the nations economic activity, but little data
on financial transactions or about what goes on in the money and capital markets.
The Flow of Funds Accounts (FFA), prepared and published quarterly by the
Board of Governors of the Federal Reserve System, provide data on financial
transactions between economic sectors. FFA traces the flow of savings into purchases
of financial assets; shows how different sectors relate to and interact with each other;
and highlights the interconnections between the financial sector and the rest of the
economy.
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A-5. Discuss the principal limitations of flow of funds data. Why must a user of
flow of funds information keep these limitations in mind?
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EXCEL 4. In the Appendix to this chapter (especially Exhibit A-2) you are given
household balance sheet information relating to the U.S. household sectors financial
assets and liabilities. Households also possess nonfinancial assets, the bulk of which is
housing. Use the information presented below along with the information in Exhibit
A-2 to examine how housing has affected U.S. household wealth since 1980.
a. For each of the years: 1980, 1990, 2000, and 2006, please place into a
spreadsheet the following information: Total Assets, Total Nonfinacial Assets,
Total Housing, Total Liabilities, and Total Mortgages.
ANSWER: Spreadsheet
U.S. Household Balance Sheet Items
($billions) 1980 1990 2000 2006
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d. For each year, compute the net equity that U.S. households have in their
home by subtracting Mortgages (liability) from Housing (asset).
ANSWER:
U.S. Household Balance Sheet Items
($billions) 1980 1990 2000 2006
e. For each year, compute U.S. households Net Worth = Total Assets Less Total
Liabilities.
ANSWER:
U.S. Household Balance Sheet Items
($billions) 1980 1990 2000 2006
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f. For each year, compute the percentage of households Net Worth that is made
up of net equity in their homes.
ANSWER:
U.S. Household Balance Sheet Items
($billions) 1980 1990 2000 2006
ANSWER: The principle trends in the make-up of U.S. households balance sheet are
that the household sector has been the net lender of funds to rest of the economy. The
percentage of the Net worth is increasing and the percentage of net equity of housing
in the net worth is decreasing.
5. The following situations may be covered by insider trading laws in the United
States. Examine each situation described and indicate whether, in your
opinion a violation of insider trading laws might have occurred. If you think
a violation occurred, what kind of violation was it?
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c. James Smith works for Cohen and Cooper, a local law firm, and while
browsing in his firms law library, he discovers a new report from a legal
client of his colleague, Roscoe Adams, that predicts serious financial problems
if the client proceeds with its recently drafted strategic plan. Smith
subsequently discovers discreetly that the strategic plan is to be launched
next week. He also learns that Roscoe is selling the clients stock short
through his broker. Smith quietly advises Roscoe not to make the short sale
and lets the matter drop.
ANSWER: Here Adams, as the attorney directly representing the company, (and who,
again, seemingly would be considered a de facto Company insider) seems to be
breaching his fiduciary duty by attempting to profit from company-proprietary
information.
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b. If you were a stock trader and markets were not efficient, how would this
influence your trading activity? What does this tell you about why markets
may be efficient?
ANSWER: If the market is not efficient, then some traders will be able to make profit
by extrapolating the patterns of profitable trading which was achieved by
manipulating the information in a market which is not efficient. However, since such
behavior is profitable, more people will be actively looking for such opportunities and
that will help push the market to be efficient.
c. Consider the case of a day trader who looks only at the past history of stock
prices in conducting his or her trades. How likely would it be for such a
person to beat the market? What does this suggest about investing in the
entire market (such as by purchasing shares in an index fund) rather than
attempting to pick individual stocks?
ANSWER: If a day trader looks only at the past history of stock prices in conducting
his trades, he must be a believer that the market is not even weakly efficient. The
weak form of the EMH argues that the current price of a financial asset already
reflects all its price and trading volume history. Since most markets are at least semi-
efficient, the trader will not be able to make money easily, let alone make easy money.
If somebody invests in an index fund / market fund instead of trying to beat the
market, she believes that the market is at least semi-efficient. The semi-strong form
contends that the current price of a financial asset already reflects all publicly
available and relevant information.
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7. Based on the material in the appendix to this chapter construct sources and
uses of funds statements for each sector and for the whole economy using the
following information:
Assume that the four sectors listed above are the only sectors in the economy
and that there are no international transactions. Is there a statistical
discrepancy? Where? Referring to the discussion in Chapter 2, which
sectors are deficit-budget sectors (DBUs) and which are surplus-budget
sectors (SBUs)? Are there any balanced-budget sectors (BBUs)?
ANSWER:
Households
Uses Sources
Change in Real Assets $332.5 Change in Liabilities $210.0
Changes in Financial Assets 306.3 Change in Net Worth 428.8
Total Uses $638.8 Total Sources $638.8
Business Firms
Uses Sources
Change in Real Assets $350.0 Change in Liabilities $148.8
Changes in Financial Assets 78.8 Change in Net Worth 280.0
Total Uses $428.8 Total Sources $428.8
Financial Institutions
Uses Sources
Change in Real Assets $17.5 Change in Liabilities $26.3
Changes in Financial Assets 43.8 Change in Net Worth 35.0
Total Uses $61.3 Total Sources $61.3
Governments
Uses Sources
Change in Real Assets $---- Change in Liabilities $43.8
Changes in Financial Assets 8.8 Change in Net Worth -35.0
Total Uses $8.8 Total Sources $8.8
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While total uses equal total sources of funds for the economy as a whole, the change
in real assets (net investment) is not equal to the change in net worth (current saving).
Nor is the change in financial assets equal to the change in liabilities as should be the
case in a closed economic and financial system. The discrepancy observed is
approximately equal to the statistical discrepancy normally found in the Flow of
Funds Accounts and usually arises from unreported transactions and differences in
accounting systems.
Deficit budget sectors include business firms and government. These sectors
experience a greater current increase in real assets than net worth and, therefore, a
greater rise in outstanding debt than in holdings of financial assets. Surplus-budget
sectors include households and financial institutions for which the change in net worth
exceeds current growth in real assets, such that the change in financial assets is larger
than the change in outstanding liabilities
Web-Based Problems
1. Go to the Internet and use such Web sources as www.federalreserve.gov,
www.bea.gov, and www.bls.gov in order to obtain the following information:
a. The latest stock price that you can find for IBM
Check: http://finance.yahoo.com/q?s=IBM
From Company Profile (as of 6/29/2007), the Close Price for IBM is
$105.25/share.
b. The average yield on highly-rated long-term bonds
Check: http://www.federalreserve.gov/releases/h15/Current/
Moody's seasoned Aaa (as of 6/22/2007) has a yield of 5.86%
c. The interest rate on 3-month U.S. Treasury bills
Check: http://www.federalreserve.gov/releases/h15/Current/
The 3-month U.S. Treasury bills (secondary market, as of 6/22/07) have a
yield of 4.59%.
d. The size of the U.S. money supply (measured as M1 and M2)
Check: http://www.federalreserve.gov/releases/h6/Current/
The seasonally adjusted in billions of dollars (as in May, 2007): M1: 1377.3;
M2: 7226.8. The non-seasonally adjusted in billions of dollars: M1: 1382.0;
M2: 7200.3.
e. The annualized growth rate of the U.S. economy for the most recent
quarter (real GDP)
Check: http://www.bea.gov/national/txt/dpga.txt
Quarterly GDP in billions dollars Annualized Growth Rate
2006q1 13,008.4
2006q2 13,197.3 2.6%
2006q3 13,322.6 2.0%
2006q4 13,458.2 2.5%
2007q1 13,620.2 0.7%
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f. The size of the U.S. budget deficit (or surplus) for the last fiscal year
Check: http://www.whitehouse.gov/omb/budget/fy2005/pdf/hist.pdf (For
Federal Budget in millions of dollars)
Receipts Outlays Surplus or Deficit ()
2007 estimate $2,415,852 $2,770,097 $354,245
g. Total business fixed investment in the U.S. during the last calendar year
Check:http://www.bea.gov/national/FA2004/TableView.asp?
SelectedTable=18&FirstYear=2000&LastYear=2005&Freq=Year in Billions of
dollars; yearend estimates
2004 2005
Private fixed assets 27,192.8 29,343.6
h. Total employment in the nonfarm business sector
Check: http://www.bls.gov/news.release/empsit.nr0.htm
Total employment in the fourth quarter of 2006 is 136,951 in Thousands and
the first quarter of 2007 is 137,447 in Thousands.
i. The inflation rate in the United States for the past year measured in terms
of the growth rate of the CPI
Check: http://www.bls.gov/news.release/cpi.nr0.htm
The May 2007 level of 207.949 (1982-84=100) was 2.7 percent higher than in
May 2006.
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