Scotts Chapter 4: Efficient Securities Market

Scotts Chapter 4: Market Efficiency

Efficiency is based on the information content of disclosure not the form of disclosure that is valued by the market Primary reason for the existence of accounting information asymmetry Accounting can be viewed as a mechanism to enable communication of useful information from inside the firm to outside to better enable investors decisions and have social benefits through improvement of operation of securities market Market fully uses all available information Efficient Securities market: Is one where prices of securities traded on that market at all times fully reflect all information that is publicly known about these securities Sources of information financial press, tips from friends, changes in economic conditions, advice from analysts and financial statements (most important) Market prices are efficient with respect to publicly known information o Insiders are able to earn excess profits at the expense of outsiders o Managers may credibly communicate inside information to market, to increase firms share price/reputation Market is efficient relative to a stock of publicly available information The efficiency of securities market Model of how a securities market operates Semi-strong form assumed Market efficiency is a relative concept which may not necessary reflect real firm value Suggest that prices are unbiased relative to publicly available information and will react quickly to new or revised information Investing is a fair game if market is efficient investors cannot expect to earn excess returns on a security/portfolio Securitys market price should fluctuate randomly over time Prices change only when unexpected events arise Different investors interpret information different, but these differences will average out and reflected in the market 1) Choice of specific accounting policy does not matter o As long as there are no differential cash flows & full disclosure is made o Accounting policies chosen will only affect reported net income but not future cash flow (e.g. full-cost vs. successful efforts approach for oil and gas company o Market is not fooled by differing accounting policies when comparing firm securities 2) Efficient securities market go hand in hand with full disclosure o Management should develop and report information about the firm on a

Definitions

Implications of market for financial reporting

Scotts Chapter 4: Efficient Securities Market timely basis o As long as benefits to investors exceeds the cost o Investors will use all available information to improve their predictions of future returns o The more information the firm discloses, the greater is the investors confidence in the securities market 3) Need not be concerned about the nave investor when choosing disclosure policies and formats o They are price-protected by the efficient market They trust that the efficient securities market will always reflect all that is publicly known about the firms o If enough investors understand the disclosed information, the market price will be the same as though all investors understand o They can hire their own experts 4) Accountants are in competition with other providers of information as the efficient market is interested in useful information from any source o A need to provide useful, cost effective information. If not, our function will decline overtime Should fluctuate randomly overtime and is only partially informative because: Presence of liquidity or noise traders These people have other reasons to why buy/sell securities (decisions come at random, not based on rational evaluation of information). Security prices are partially informative in presence of noise traders but still efficient (expected value sense) Security prices respond less to financial statement information for large firms than for small firms, since they are more in the news => market price will incorporate considerable information. When people are not independent in their views. The price is biased when they collectively have the same views on a security If prices fully reflect available information, there is no motivation for investors to acquire information prices will not fully reflect available information

Market Prices

Information asymmetry presence of inside information *note that market prices are still efficient in the presence of noise trading, but in the expected value sense, since noise has an expectation of zero.

Scotts Chapter 4: Efficient Securities Market Depends on how informative price is The quality of financial statement information The costs of analysis and interpretation Leads to predictions about how security market prices respond to financial statement information. Security prices of large firm will respond less to financial statement information than for small firms large firm release more information Voluntary disclosure, beyond the minimum requirements of GAAP (limitation: management may not disclose information that gives away their competitive advantage) Management can signal inside information by its choice of accounting policies Increase the quality through Management discussion and analysis Government to impose penalties on the market Current Price = (Expected future price + Dividends) / (1 + E(Ri) Suggests that risk free return, market return & beta determine expected returns of a firm E(Ri) = Rf + Bi [E(RM) - Rf] 3 main uses: o Show how share prices depend on investors expectation of future share price and dividends o Provides us with a way to separate the realized return on a share into expected and unexpected components( ex post separation) o Convenient way to estimate the stocks beta Does not consider information asymmetry o Investors face the risk of insider trading and demand higher returns Information known by one participant in the market may not be known by another buyer vs. seller Major information advantage over the other participant o Adverse selection problem people whose health is adverse selfselect themselves to buy insurance OR using insider information to trade, which is adverse to the interest of investors o Moral Hazard problem Cheat the company by failing Securities market is subjected to information asymmetry problems such as insider trading/insider information o Take advantage of their information to earn excess profits by biasing, delaying, or withholding its public release while they buy or sell shares on the basis of this information. Ideal conditions price reflect fundamental value (Value of the share with no inside information present)

Extent which investors gather information

How to improve financial reporting

Capital asset pricing model/ market model

Information Asymmetry

Scotts Chapter 4: Efficient Securities Market Non ideal market value fully reflects all publicly available information in an efficient market Non ideality is caused by inside information and may lead to adverse selection( attracting outsiders that threaten the true state of the firm) o Reduce this problem with full and timely disclosure o Improving policies of full disclosure, to expand the set of information that is publicly available and reduce biases. Investors realize that it is not a level playing field and either withdraw from the market or lower the amount they are willing to pay for any secrurity Social significance of securities market that work well Social welfare will be enhanced if scarce capital goes to most productive alternatives To prevent lemons phenomenon that come into play because of adverse selection and moral hazard o People withdraw from the market a thin market o Willing to pay less for any security o Signaling to credibly communicate information to the market for firms with high quality investment Engage in full disclosure to remove own company from the lemons category hence investors are more willing to invest in them Impose penalties on the market Regulations such as SEC in the US Provide incentives for the release of inside information through signaling