Chapter 3

The Financial Information

Marketplace

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies,

 Learning Objectives
To identify important sources of information
about the financial system.
To understand why the efficient distribution of
information within the financial system is so
important.
To learn how market participants keep track of
the prices of financial assets, interest rates,
and other financial variables.
To learn about the flow of funds accounts and
discover what is meant by social
accounting.

3-3

Introduction
Sound financial decisions require
adequate and reliable financial
information
Sources of information relied on by
financial decision makers

Debt security prices and yields

Stock prices and dividend yields
Information on security issuers
General economic and financial conditions
Social accounting data
3-4

The Great Debate Over

Efficient Markets & Asymmetric Information

Efficient markets hypothesis (EMH)

contends that information relevant to the
pricing (valuation) of loans, securities, and
other financial assets is readily available to
all borrowers and lenders at negligible cost.

3-5

The Great Debate Over

Efficient Markets & Asymmetric Information

The other view is asymmetric information

Pockets of inefficiency in information
availability
Pockets of inefficiency in use of information

Some market players possess better

information

Can have special information

Information may be costly for other parties
Insiders can earn excess returns by
selectively trading financial assets based on
special information
3-6

The Great Debate Over

Efficient Markets & Asymmetric Information

An efficient market
Each individual investor will rationally use
all relevant information for valuation
Neither wastes nor misuses information
Do not systematically ignore
information to earn profits

3-7

The Great Debate Over

Efficient Markets & Asymmetric Information

Financial markets today may have

many profit-maximizing, well-informed,
intelligent investors
Wont be profitable asset trades over time
No systematic mispricing of assets
Temporary deviation of actual returns from
expected should be quickly eliminated
Each financial asset will generate an
ordinary, normal or expected rate of return
commensurate with its level of risk

3-8

Different Forms of the EMH

The weak form of the EMH argues that the
current price of a financial asset already reflects
all its price and trading volume history.
The semistrong form contends that the current
price of a financial asset already reflects all
publicly available and relevant information.
The strong form argues that the current price of
a financial asset already captures all relevant
public and private information.

3-9

Different Forms of the EMH

Evidence
Subject to repeated research studies
Tend to support the weak and semistrong
forms

The strong form has aroused the most

controversy
Existence of insider trading activities
Apparent presence of pockets of special
information asymmetrically scattered
throughout the financial system
3-10

Insiders & Insider Trading

Insiders
People associated with the firm
Information superior to general market

Insider trading
Buying or selling a financial asset
Superior inside knowledge or privileges
Manipulative or deceptive device in trading
forbidden
Insiders not prohibited from trading
securities

3-11

Insider Trading Counterargument

Restrictions may hurt firms efficiency
Discourage taking of risk
Limit managerial incentive to perform

Businesses should decide

May improve market efficiency
Encourages release of private information
Prices correct more quickly
Reduce risk to investor
3-12

Insider Trading Enforcement

Corporations monitor employee stock
trading
Civil and criminal penalties
Negative publicity

Difficult to get away with

Greater surveillance
Monitored by various parties
Corporations
Stock exchanges
Security trading firms
3-13

The Asymmetric Information

Hypothesis (AIH)
Alternate hypothesis: Some
individuals and institutions have
access to pockets of information
concerning the true value and risk of
financial assets and others simply did
not

3-14

The Asymmetric Information

Hypothesis (AIH)
Pockets of special information
Expertise
Experience
Location

Inefficient incentives
Incentive to misrepresent quality of
information sold
Information may lead to market
inefficiency
Inconsistent with strong form efficiency
3-15

Problems Asymmetries Can Create

Lemons and Plums. A loan officer (buyer)
cannot be sure without incurring substantial
costs whether his or her potential customer
(seller) is a lemon (low quality) or plum
(high quality).

3-16

Problems Informational
Asymmetries Can Create
Lender does not know customer quality
Customer has incentive to misrepresent if
low quality
Loan pricing reflects the likelihood of the
loan being low quality
The pricing is above what a high quality
borrower should be charged
High quality borrowers leave the market

Need a mechanism beyond pricing to

optimally allocate resources

3-17

Problems Informational
Asymmetries Can Create
Adverse selection
Asymmetric information before a contract
completed
One party only chooses contracts that will
benefit self

3-18

Problems Informational
Asymmetries Can Create
Bank that sets one price for all
checking account customers
High-balance, low-activity (and hence
most profitable) customers tend to
overpay and avoid contract
Low-balance, high-activity customers
tend to underpay and prefer contract
Solution: Enable customer signaling via a
conditional price schedule for different
account plans
3-19

Problems Informational
Asymmetries Can Create
Moral hazard
Asymmetric information after agreeing to a
contract
One party in a contract may decide to
pursue its own self-interest at the expense
of the other party
Poorly drafted contracts
Ineffective monitoring activity

Solution: Draw contracts with the

appropriate incentives
3-20

Asymmetry, Efficiency, &

Real-World Markets
All real-world markets have elements of
both efficiency and asymmetry
Perhaps real-world markets are split
into segments
Highly efficient segment with well-informed
traders
Less efficient segment with less-wellinformed small investors trade
3-21

Informational Asymmetries
and the Law
Some laws and regulations are
designed to improve the flow of
information between
Not always successful
Unintended consequences
Avoided by many non-corporate
participants

3-22

Informational Asymmetries
and the Law
U.S. examples:
1934 Securities Exchange Act
1940 Investment Company Act
1970 Securities Investor Protection Act
Regulation FD (Fair Disclosure), 2000
2002 Sarbanes-Oxley Accounting
Practices Act

3-23

Behavioral and Experimental

Behavioral and experimental finance
Creating basic experiments to test behavior of
market participants
Participants asked to make decisions in a
simplified economy
Helps to isolate a single factor influencing the
markets
Controls for others
Unable to do in complexity of real economy
Still a new and evolving field
3-24

Discovered Principals
Only the best-informed traders
appear to outperform less-informed
traders
Investors who purchase market
research information do not, on
average, achieve greater net returns
than investors who do not

3-25

Discovered Principals
Financial markets are able to
dispense information efficiently
through both verbal and nonverbal
communications(e.g. price and
volume)
Financial markets tend not to
gravitate toward those market
participants who assign the highest
value to those assets based on the
latest information
3-26

Sources of Information
Alternately sources abound to provide
information to investors
Data: bid & ask prices, yields-to-maturity
Sources: real-time computer networks (e.g.
Reuters, Bloomberg), televised reports (e.g.
CNN, CNBC), financial press (e.g. The Wall
Street Journal)
Data: bond yield indexes
Sources: Moodys Investor Service, The Daily
Bond Buyer, U.S. Treasury, Dow Jones
3-27

Sources of Information
Indicators of Average Bond Yields
(Average Annual Yields in Percent)

Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, selected issues
3-28

Sources of Information
Stock prices and dividend yields
Data: prices (year-high, year-low, day-high,
day-low, closing), sales volume, most recent
dividend, dividend yield, P-E ratio, stock
price indexes (e.g. DJIA, S&P500, Wilshire
5000), foreign stock prices
Sources: computer networks (e.g. Internet),
financial press, television, radio, financial
institutions (e.g. S&P, Morningstar)
3-29

Sources of Information
Security issuers
Data: firm history, principal
products/services, key officers, recent
operation summary, financial statements,
credit ratings, industry performance
indicators
Sources: regulatory agencies (e.g. SEC),
trade associations, commercial institutions
(e.g. Moodys, S&P, Dun & Bradstreet),
directories & databases, journals &
magazines, credit bureaus
3-30

Sources of Information
Stock price indexes and foreign stock prices
Data: stock indicies, index composition,
sector indicies, indicies by size, market-value
weighted indicies, international stock
markets, currency exchange rates
Sources: computer networks (e.g. internet),
financial press, television, radio, financial
institutions (e.g. S&P, Wilshire), Federal
Reserve
3-31

Sources of Information
General economic and financial conditions
Data: interest rates, money supply measures,
industrial output, international transactions,
unemployment rate, inflation, forecasts
Sources: central banks (e.g. the Federal
Reserve), statistical bureaus (e.g. Bureau of
Economic Analysis), financial press

3-32

Markets on the Net

American Economic Association at
http://www.aeaweb.org
Answers.com at
answers.com/topic/random-walk-hypothesis
Bank of International Settlements at bis.org
Bloomberg at bloomberg.com
Bond Market Association at investinginbonds.com
Bondsonline at www.bondsonline.com
CNBC at www.cnbc.com
Comptroller of the Currency at www.occ.treas.gov
Computer Data Industry Association at
cdiaonline.org
3-33

Markets on the Net

Dun & Bradstreet at www.dnb.com
Economagic.com at economagic.com
Euromoney.com at euromoney.com
Equifax at www.equifax.com
Experian www.experian.com
Federal Deposit Insurance Corporation at
www.fdic.gov
Federal Reserve at federalreserve.gov/releases
Federal Reserve Bank of St. Louis at
research.stlouisfed.org/fred2
FINIX European Stock Market Indices at
www.finix.at/
Financial Times at www.ft.com
3-34

Markets on the Net

International Monetary Fund at www.imf.org
Investment Company Institute at www.ici.com
Investopedia at investopedia.com
/university/concepts
Investor Home at investorhome.com/emh.htm
Money Magazine at money.cnn.com
Moodys Investors Service at www.moodys.com
Morningstar at morningstar.com
Motley Fool at fool.com
MSN Money at moneycentral.msn.com
New York Stock Exchange at www.nyse.com
3-35

Markets on the Net

NASDAQ Stock Market at www.nasdaq.com
Office of the Comptroller of Currency at
occ.treas.gov
Quote.com at new.quote.com
RePEc at ideas.repec.org
Risk Management Associates at rmahq.org
Securities and Exchange Commission at
www.sec.gov
Social Science Research Network at
www.ssrn.com
Standard and Poors Corporation at
stockinfo.standardpoor.com
3-36

Markets on the Net

Stock Smart at stocksmart.com

Transunion at www.transunion.com
U.S. Department of Commerce at
www.doc.gov/
U.S. Department of Treasury at
treasury.gov/press/releases
Valueline at valueline.com
Wall Street Journal at www.WSJ.com
Wilshire 5000 index at www.wilshire.com
3-37

Chapter Review
Introduction: Importance of information
in the financial marketplace
The great debate over efficient markets
and asymmetric information
The Efficient Markets Hypothesis (EMH)
What is an efficient market?
Different forms of the EMH
Insiders and insider trading
The concept of asymmetric information
3-38

Chapter Review
The great debate over efficient markets
and asymmetric information
Problems informational asymmetries can
create
Lemons and plums
Adverse selection
Moral hazard
Asymmetry, efficiency, and real-world markets
Informational asymmetries and the law
3-39

Chapter Review
Sources of information

Debt security prices and yields

Stock prices and dividend yields
Security issuers
General economic and financial conditions

Social accounting data

National Income and Product Accounts
The Flow of Funds Accounts
3-40

Appendix
Social Accounting

3-41

Social Accounting Data

Social accounting refers to the system of
record keeping that reports transactions
between the principal sectors of the
economy, such as households, financial
institutions, corporations, and units of
government.
The two most closely followed social
accounting systems in the U.S. are the
National Income and Product Accounts and
the Flow of Funds Accounts.
3-42

National Income and Product Accounts

The National Income and Product Accounts
(NIPA) present data on the nations
production of goods and services, income
flows, investment spending, consumption,
and savings.
In particular, the Gross Domestic Product
(GDP) measures the market value of all
goods and services produced in the
economy within its geographical boundaries.

3-43

National Income and Product Accounts

The Components of the U.S. GDP, 2006 ($ billions, current)

Source: U.S. Dept of Commerce and the Federal Reserves Flow of Funds Accounts
3-44

Flow of Funds Accounts

Flow of Funds Accounts
Traces the flow of savings
Businesses, households and
governments
Purchases of financial assets
Show interaction of various parts of
financial system
Highlight interconnections between the
financial sector and the rest of the economy
3-45

Flow of Funds Accounts

Four basic steps of construction
Sectoring the economy
Building sector balance sheet
Preparing sources and uses of funds
statements
Building a flow of funds matrix for the
whole economy

3-46

Financial Assets and Liabilities

for the Household Sector

Source: The Federal Reserves Flow of Funds Accounts.

$ Billions, Outstanding at Year-End

3-47

Sources and Uses of Funds Statement

for the U.S. Banking Sector, 2006

Source: The Federal Reserves Flow of Funds Accounts. ($ Billions) *Annualized data from Q1. 3-48

Total Net Borrowing and Lending

in Credit Markets

Source: The Federal Reserves Flow of Funds Accounts. ($ Billions) **Annualized data from Q1.
3-49

Funds Raised in
Credit and Equity Markets

Source: The Federal Reserves Flow of Funds Accounts. ($ Billions) *Annualized data from Q1. 3-50

Flow of Funds Accounts

Estimates useful for forecasting of
lending, borrowing, and interest rates
However, these social accounts do
have a number of limitations:
Transactions among economic units within
each sector are not captured
Flows that occur within the time period
under study are not captured
The market-value bias of the data distorts
actual savings and investment activity
3-51