Financial Accounting Theory

Seventh Edition

William R. Scott

Chapter 4

Efficient Securities Markets

Chapter 4 Efficient Securities Markets

4.2 Efficient Securities Markets

• Definition (Semi-strong form)

– At all times, market price of a security fully reflects all publicly available

information about that security

• Characteristics of market efficiency

– Security prices do not reflect inside information

– Efficiency is a relative concept, defined relative to a stock of publicly available

information

– Investing is a fair game—no bargains

– Security prices fluctuate randomly over time

• Efficiency is a theoretical ideal

– The question of how close actual security markets are to this ideal is discussed

in Chapter 6

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

4.4 The Informativeness of Price

• If market is fully efficient, share prices fully reflect all publicly

available information. That is, prices are fully informative about

value

– If share prices are fully informative, noone would bother to gather

information, since can’t beat the market (fair game)

– If no one gathers information, share prices will not reflect all publicly available

information

– If share prices do not reflect all publicly available information, investors will

gather information. Share price will quickly become fully informative

– Then, noone would bother to gather information, etc., etc.

– Hence a logical inconsistency

>> Continued

The Informativeness of Price (continued)

• A way out of the logical inconsistency

– Noise trading

• Expected value of noise = 0

• Share prices still efficient, but in an expected value sense

– Share prices are partially informative in presence of noise trading

• Share price may deviate from its efficient value due to noise trading

• Restores incentive of investors to gather information

>> Continued

4.4 Something Does Not Sound Right

• Our story of informed investors making prices reflect all information

resulting in efficient market

• One inconsistency

1. If market is efficient, then no one can earn excess return, and everyone earns

their fair / normal return

2. So if no one earns excess return, why waste time and effort to analyze

3. So if no one spend time to collect and analyze the information, the market can

no longer be efficient

• Sounds like chicken and egg problem or free rider problem (or your

group with no leader, group of friends with no destination)

• Add one detail to the efficient market model

• Liquidity traders or noise traders

– They buy or sell for unpredictable or personal reasons which are not market

driven

– e.g. need money for hospital, hot tips, irrational reasons

• The liquidity and noise traders move prices, and informed traders can

make excess return if they can decide the truth

• So informed traders will collect and analyze information again

4.4 Something Does Not Sound Right

4.4 Something Does Not Sound Right

Companies also help by providing other information

Management discussion and analysis (MD&A) in annual reports provides

forward looking or more detailed information on company

1. Signaling by management of current company value and future

performance

– Shares buyback / repurchase vs share issuance

• Buy back shares if current market price is undervalued

• Issue new shares if current market price is overvalued

– Change in dividend level

• Generally stable dividend level preferred

• Increase dividend level means management have confidence on future

performance

4.5 A Capital Asset Pricing Model

• CAPM

E(Rjt) = Rf(1 - ββββj) + ββββjE(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:

>> Continued

Concept of a Security’s Beta

• Beta measures the covariance of security’s return j with

market portfolio return M

βj = Cov(j, M)/Var(M)

• Measures risk contributed by a security to a fully

diversified portfolio

• Var(M) is the variance of the market portfolio

(A standardization device so that betas from securities traded on different

markets can be compared)

4 - 11

A Capital Asset Pricing Model (continued)

• 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

• Section 4.5.2 (optional section) Critique of the CAPM

– CAPM assumes rational expectations

• Investors assumed to know beta

• In practice, investors do not know beta, so must estimate it, creating

estimation risk

– CAPM assumes common knowledge

• Everyone knows that everyone knows beta, etc.

• This rules out sophisticated investors’ ability to take advantage of ordinary

investors who have inferior knowledge of beta

– CAPM assumes no transactions costs and liquid markets

– CAPM assumes rational investors

– Despite these limitations, CAPM is a good place to start to appreciate the role

of information in capital markets

A Capital Asset Pricing Model (continued)

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

• Investor reaction to inside information

– Inside information another source of investor estimation risk

– The lemons problem (Akerlof (1970))

• Would you buy a used car from someone you do not know?

• If so, how much would you pay?

– Would you buy a share in the presence of inside information?

• No, withdraw from market, market collapses (e.g., post-Enron, post 2007-

08 market meltdowns), or

• Yes, but pay less, to protect against estimation risk

» Continued

4.6 Information Asymmetry

• Effect of estimation risk on share prices

– Efficient market price includes a “discount” for expected estimation risk (i.e.,

for expected losses at the hands of insider trading)

• In effect, investors demand a higher return

– Then, CAPM may understate cost of capital, since ignores estimation risk

• To some extent, estimation risk may be diversified away, but, since outside

investors more likely to lose than gain from insider trading, some discount

will remain

» Continued

4.6 Information Asymmetry

• 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?

• Definition of markets that “work well”

– Low estimation risk, share prices as close to fundamental value as is cost

effective

4.6 Information Asymmetry

A Graphical Illustration of Estimation Risk

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)

» Continued

• Social role of financial reporting

– To help markets work well

• Maximize amount of publicly available information

• Subject to a cost-benefit constraint

• Social role of financial reporting is enhanced if securities markets are

efficient

– Then, market fully uses financial accounting information

4.7 Social Significance of Markets that

Work Well

Exceptions to Efficient Markets

• Securities markets are efficient and everyone earns a fair return

corresponding to their risk level?

• There are some exceptional situations

• Pockets of inefficiencies

– Illiquidity, e.g. private equity, venture capital

– Ability to collect and process information, e.g. real estate

– Rules and regulations, e.g. non-investment grade bonds

• Behavioral finance

– Asymmetric risk aversiveness of investors

– Investor biases