EFFICIENT SECURITIES
MARKETS
David Chu
Richard Persaud
Jeffrey Rousset
Stephen Storey
Overview
• Meaning of efficiency
• Implications for financial reporting
• Capital asset pricing model
• Information asymmetry, insider trading, adverse
selection
• Social significance
• Management discussion & analysis
• Sun Airlines, Inc.
Meaning of Efficiency
• How well information reflects security prices
• Strong Form Efficiency
• Semi-Strong Form Efficiency
Implications
1. Not all information is publically known
2. Efficiency is a relative concept
3. Investing is “fair game”
4. Security market prices can change randomly
Market Prices & Information
How?
• Consensus forecast
Assumptions:
• Investors are knowledgeable and rational
• Investors are acting independently
Implications of Efficient Markets
• Security markets have 4 major implications for
financial reporting
1. Firms accounting policies do not affect
security prices
•
Must Disclose policies to users of financial
statements
2. Information should be revealed if benefit >
cost
Implications of Efficient Markets
3. Firms should not be concerned with “naïve”
investors
•
•
Market will be brought to equilibrium price with
informed investors
“Naïve” investors become price protected
4. Accountants are in competition to provide
useful effective information
Market Inconsistencies
• If there is market efficiency (fully informative
market), then why would investors spend large
amounts to obtain information
• Would create a cycle were securities would and then
would not reflect the information that was available
• Some buy/sell decisions occur at random and do not
reflect relevant information
• IE. Noise Trading
Market Information
• Issuance of financial statements lead to greater
affect on small companies than large
• Management can share inside information to
increase security prices
Sharpe-Litner CAPM
Rjt = Pjt + Djt – Pj,t-1 = (Pjt + Djt) - 1
Pj,t-1
Pj,t-1
Where;
Rjt = the net rate of return on share j in time t
= the price of share j at the end of period t
= the price of share j at the end of period t-1
= dividends paid by firm j during period t
Ex Post and Ex Ante Returns
• Returns for a security can be examined from 2
different time perspectives. Ex post, we look at actual
returns from the end of a time period. Alternatively, you
can look Ex Ante at expected returns over the coming
period. This following equation reflects this forward
looking approach.
E(Rjt) = E(Pjt + Djt) - 1
Pj,t-1
The formula reflects securities market efficiency.
Market-wide Perspective on Risk
• Consider the economy with a large number of
rational, risk-averse investors, who come
together to form a market perspective on risk.
• E(Rjt) = Rf(1 – βj) + βjE(RMt)
Or
• E(Rjt) = Rf + βj(RMt - Rf)
• Where;
• βj = the beta of stock j
• Rf = the risk free rate in the economy
Ex Ante View on Returns
• Recall from prior slide;
• E(Rjt) = Rf(1 – βj) + βjE(RMt)
• When taking the ex ante view, the expected
return equals an expectation about the market
return, plus a constant Rf(1 – βj).
• This constant on the securities market line is
called αj.
Market Model
• By reverting back to the ex post model of returns,
the following model allows investors to separate
the realized return on a share into expected and
unexpected components.
• Rjt = αj + βjRMt + εjt
• Where;
• εjt = the unexpected return of a security
Assumptions of CAPM
1. Assumes rational expectations (Investors know
beta and market return premium)
• Leads to estimation risk of these factors
2. Consider information asymmetry only to a
limited extent
• Investors face a risk that insiders may profit at
their expense, due to non-public inside
information
Moral Hazard and Adverse Selection
• There are 2 major types of information
asymmetry
1.
Adverse Selection
•
2.
Ex. The tendency of those in dangerous jobs or high risk
lifestyles to get life insurance.
Moral Hazard
• Ex. Salesman paid with flat salary will not be incentivized
to make new sales
Information Asymmetry
Efficient Market
Price of Firm
Publically Available
Information About Firm
Role of Financial
Reporting
Inside Information
Fundamental Value
of Firm
Social Significance
• Countries with more firm-specific information
incorporated into share prices means there is less
inside information
• Information is incorporated through high quality
reporting
• High quality reporting can be obtained through
regulations such as accounting standards
• High quality reporting reduces under and over
investment
• Can result in higher share prices, lower cost of capital
Social Significance cont’d
Social benefits will be attained if:
• All useful information is publicly available, at least
up to the ability of penalties and incentives to
cost-effectively motivate high quality earnings
• Securities market prices are efficient relative to
publicly available information
Management Discussion & Analysis
(MD&A)
• Narrative explanation of company operations, to
assist investors to interpret financial statements
• Company performance, financial condition, risks,
and future prospects
• Greater importance on relevance than reliability
• Emphasizes full disclosure
• Written in plain language for everyone to interpret
Sun Airlines, Inc.
Question
What is the difference between “strong form
efficiency” and “semi-strong form efficiency?
Answer
Strong form efficiency considers ALL information
and semi strong efficiency only considers ALL
PUBLICALLY KNOWN information.
Question
What are the four implications with the theory of
efficiency?
Answer
1. Not all information is publically known
2. Efficiency is a relative concept
3. Investing is “fair game”
4. Security market prices can change randomly
Question
What is the definition of a Noise Trade?
Answer
• A security’s price changes at random with no new
information about a security
• Ex. Tip given out about security to buy or sell
Question
Why do financial statements not need to be
prepared so a “naïve” investor can understand
them?
Answer
Informed investors will trade the security until it
fully reflects all of the available information
Question
If the beta of a stock is 1.5, how volatile is the
stock relative to the market?
A. 150% more
B. 50% more
C. 50% less
D. 150% less
Answer
B) 50% more
Question
In the market model of a securities return, what
does the component εjt represent?
Answer
εjt represents the abnormal or unexpected return of the
stock j in time t.
Question
Which constant represents the intercept of the
securities market line?
A. α
B. β
C. ε
Answer
• A. α is the constant on the securities market line
Question
The _______ value of a share is the value it would
have in an efficient market if there is no inside
information. That is, all information about the firm
is publically available.
Answer
Fundamental value of the share
Question
If too many investors withdraw, the market loses
depth, where depth is the number of shares that
investors can buy or sell without affecting the
_____________?
Answer
• Market price
Question
The MD&A is a narrative explanation of the firm’s
operations, to assist investors to interpret the firm’s
______________?
Answer
Financial statements