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A relative concept: Efficiency defined relative to a stock of publicly available information. Market is not all-knowing and price does not necessarily reflect underlying firm value.
Efficiency: When new or corrected information becomes available in the market the share price will quickly adjust to it.
Fair game: Investing is fair game if market efficient, that is, cannot get above expected returns (refer CAPM model later)
Random walk: A share market price often shows serially uncorrelated behavior as compared to, for example, downturn due to industrial accident.
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Beaver argued that different accounting policy choice by firms will not matter unless there is a cash flow effect.
Thus efficient market argument is that full-disclosure of accounting policies and any additional information to convert accounting information between firms will allow decisions.
Nave investors (Fama, 1970) may not impact market efficiency because although individuals do not have complete knowledge or understanding, the knowledge of the whole market will result in price-protected investors.
Fully informative share prices y No one would bother to gather information, since cant beat the market y If no one gathers information, share prices will not reflect all publicly available information Partially informative share prices y Share prices not fully informative since market price may be wrong in presence of noise y Share prices now only partially reflect publicly available informationthey also reflect noise y Investors now have incentive to gather information Role of Voluntary Disclosure
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INFORMATION ASYMMETRY
The value of a firms share on an efficient market if all information about the firm is publicly available (i.e., no inside information)
Inside information
y
Insiders may exploit their information advantage to earn profits at the expense of outside investors
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Measures the relationship between market price of a security, its risk and expected rate of return. The price of a share will behaves as if the market has a certain expectation about its future performance.
Performance of future price and dividends. y CAPM measures beginning of year expected returns and possible abnormal returns. y Beta risk and returns may be known by investors but estimation risk explains these may not be accurately know.
y
Efficient market price includes a discount for estimation risk i.e., investors demand a higher return CAPM understates cost of capital, since ignores 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
y
Low estimation risk, share prices as close to fundamental value as is cost effective
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In a capitalist economy, allocation of scarce capital to competing demands is accomplished by market prices y 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 y Society is better off the closer are share prices to fundamental value (i.e., if markets work well) Social role of financial reporting y To help markets work well Maximize amount of publicly available information Subject to a cost-benefit constraint Requires securities market efficiency
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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
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THE END
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