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Chapter 4: Efficient Securities Markets
The Meaning of Efficiency: A market is efficient when security prices reflect all the available
information. Under ideal conditions, information is free and investors have the opportunity to
take advantage of available information and make rational decisions about securities prices in the
market. Under non-ideal conditions, information is not free and investors have to do cost benefit
analysis in order to decide how much information they acquire to make rational decisions. There
are three types of efficient markets: weak form, semi-strong form, and strong form. We will
discuss only semi-strong markets where all publicly available information about specific
securities is reflected in securities price. When new information enters the securities market,
prices will adjust quickly because investors will revise their prior beliefs. They will start selling
and buying securities based on their new beliefs and this will cause changes in prices. It means
that market prices are relative to publicly available information. Fluctuation in the market is
expected due to the seasonal nature of business, or retirement of key employees, etc. The time
series in which a particular securities price has random fluctuations, over a period of time, is
called random walk.
How do Market prices properly reflect all available information? The notion that market
prices reflect the information available is explained by decision theory. We know from previous
chapters that rational, informed investors will demand all available information on securities.
This theory does not guarantee that each investor’s decision will be same. Each investor’s
decision will differ based on their prior beliefs as one or more inputs may differ. For example,
investors may misidentify one or more probabilities required by Bayes’ theorem. If a specific
number of investors interpret information properly they will make proper buy and sell decisions
about securities. Other investors will follow their recommendations and the resulting prices will
properly reflect all available information in a timely manner.
Capital Asset Pricing Model: The Capital Asset Pricing Model explains the relationship
between the efficient market price, risk, and the expected rate of return on a security. The model
answers the question, how do the investors find the rate of return on their investment? The rate of
return on a share = (the price at the end of period + dividends paid) / price at the beginning of
the period of a share. One is then subtracted from this value. We can also find the expected
return on a share by using the expected price plus any dividends expected at the end of period.
Thus, the CAPM relationship is: E (Rjt) = Rf + Bj [E (Rmt) – Rf] where Rf is rate of return on a
risk free asset such as T-bills, Bj is the beta of security j, and Rmt is the return on the market
portfolio for period t. This model takes risk factors into account, denoted by beta of the security
j. There are two types of risk: systematic risk and non-systematic risk. Non-systematic risk is
firm specific, which can be eliminated in a diversified portfolio and does not affect share price.
Systematic risks are economy-wide, as all firms will be affected by these factors in turn affecting
share price. Beta can also change over time if the risk of a firm or industry changes.
What is an Anomaly? Efficient securities market anomalies are investor behaviour that appears
to contradict the theory of efficient markets. Rational single-person decision theory is called into
question.
Prospective theory: An investor considering a risky investment (a prospect) will evaluate
separate prospective gains or losses. The utility for gains is concave and risk averse while the
utility for losses is convex, and “risk taking”. Investors weight payoff probabilities. This can
lead to irrational behaviour, which turns anomalous if many act this way.
Behavioural finance: This is the study and documentation of abnormal security returns
persisting for a length of time following an information event.
Post-announcement drift: When good news (GN) is reported, abnormal security returns drift
upwards for at least sixty days. When bad news (BN) is reported, abnormal security returns drift
downwards for at least sixty days.
The reason this occurs is the artifact of earnings expectation model used by researchers is
up in the air. However, investors seem to underestimate the implications of current earnings for
future earnings. As well, the correlation between GN in one quarter and the next is
underestimated.
Market efficiency with respect to Financial Ratios: The market waits so details appear of the
strategy to beat the market. Ou and Penman (OP) calculated 68 ratios for a number of firms.
They saw that ratios predicted net income (NI) rising or falling in the next year. The best ratios
were used as independent variables to estimate a multivariate regression model to predict
changes in the next year NI. This is an anomaly for efficient securities market theory.
Market response to Accruals: NI is equal to operating cash flows (CF) plus net accruals. Net
accrual includes items such as amortization expense or accounts payable. Efficient markets
should react more strongly to one dollar of GN in NI if the dollar comes from operating CF
rather than accruals, as they reverse.
Discussion: Explaining anomalies without leaving the efficient securities market theory was
attempted with “risk”. But, rewards from risky stocks were not driving results. The firm size
explains share returns in addition to beta. Results from OP reflect a permanent difference in the
expected returns such as firm size or risk, rather than deviation from fundamental value.
Transaction costs are another explanation for anomalies, as these costs limit the ability of
investors to exploit post-announcement drift. So, unless we know what the cost of an investment
strategy should be, we won’t know whether profits earned are anomalous.
Implications of Efficient Securities Markets for Financial Reporting: The first implication is
accounting policies adopted by firms don’t affect their security prices, as long as policies are
disclosed, have no differential CF effects, and information is given so readers can easily convert
across policies. The second implication is that efficient securities markets go hand in hand with
full disclosure. The next implication is that market efficiency implies financial statement
information doesn’t need to be presented in an elementary form for everyone to understand.
Naïve investors are price-protected as they can trust the efficient market to price securities.
Finally, if accountants didn’t provide useful, cost-effective information, the usefulness of this
function would decline to other information sources.
The Informativeness of Price: In efficient markets, the price of a security is fully informative; it
fully reflects all available information of that security. Since information gathering is costly, and
investors could not expect to beat the market, they will not be motivated to gather information.
The logical inconsistency is this: if prices fully reflect available information, investors will not
gather information; hence, prices will not fully reflect available information. The potential
implication of this inconsistency is that financial statements may not be useful to investors.
The inconsistency is avoided because of the presence of liquidity traders or noise traders.
These types of investors are irrational and make buy/sell decisions at random. As a result, share
prices are only partially informative as they are now mispriced. Rational investors can gather
more information about securities by carefully analyzing financial statements. Hence, financial
statements are useful to investors. Their usefulness can be enhanced by MD&A’s and FOFI’s.
Information Asymmetry: Securities markets are subject to information asymmetry problems.
Namely, it is likely that insiders know more than outsiders about the true quality of the firm, and
the possibility exists that insiders will take advantage of this information to earn excess profits.
This situation is an example of adverse selection. Investors are aware of this possibility and will
lower the amounts they are willing to pay for shares. Thus, the securities markets do not work as
well as they might. Financial reporting serves to reduce the adverse selection problem, thereby
improving the operation of securities markets. Specifically, the full disclosure policy serves to
expand the set of information that is publicly available. Also, timelines of reporting will reduce
the ability of insiders to profit from their information advantage.
Social Significance of Properly Working Securities Markets: There is a social significance of
properly working securities markets. If information asymmetry exists, firms with high-quality
investment projects will not receive a high price for their securities, and the market is not
working as well as it should. However, penalties against insider trading and the requirement of
full disclosure are mechanisms by which the smooth operation of securities markets is
maintained.
Full Disclosure: Efficiency in the securities market is based upon the underlying principle of
publicly available information. While a company’s financial statements reveal to us valuable
information about their current financial standings, investors often desire to know more about a
particular company in order to make informed investment decisions. For this reason, many
companies follow a policy of full disclosure through the use of accounting standards such as
Management Discussion and Analysis (MD&A) and Future-Oriented Financial Information
(FOFI).
In accordance with Statement 5.10 and the Ontario Securities Commission (OSC),
MD&A is required for large firms (i.e. those firms with shareholder’s equity and revenues in
excess of $10 million), but is optional for all others. MD&A focuses on the decision usefulness
approach, attempting to provide users with relevant information to assess the future prospects of
a firm. The MD&A disclosure requires discussions on current operations and financial
conditions, risks and uncertainties, financial instruments, known trends, and any other
information that is not clearly presented in the financial statements, but which can be obtained
“without undue effort or expense” to the firm. MD&A is separate from the financial statements,
however, its purpose is much the same – to provide investors with useful information that allows
them to assess the future prospects of a firm.
FOFI is another financial forecasting standard that aims to further expand the information
available to investors. Under Section 4250 of the CICA Handbook, FOFI is not required.
However, many firms choose to engage in this standard to enhance their reputation for full and
timely disclosure to their users, and in the case of smaller corporations, to reveal more
information about themselves to the public. It is suggested that FOFI not exceed a period of
approximately one year, for beyond such a time the information may not be reasonably
estimated. In order to maximize the usefulness of FOFI, it is formatted in such a way that is
commonly known and understood by users. Providing a linkage between past and future results,
FOFI allows for comparability over time and provides disclosures that are important and
potentially useful to investors.
Full disclosure through the use of MD&A and FOFI standards allow companies to
communicate information to the public beyond what is presented in their conventional financial
statements. Investors can learn a lot about a firm based on the information that they disclose and
to what extent they disclose it.
CHAPTER 4 QUESTIONS AND SOLUTIONS
Q: 1
Solution:
What are the three forms of efficient market?
Weak market, Semi-strong market, and Strong market.
Q: 2
Solution:
What is a Semi-Strong Market?
Semi-Strong Market is a market where all public available information reflects
securities price.
Q: 3
Solution:
Are all information costs free under ideal condition?
yes, under ideal conditions, all the investors know all information since the state
realization is publicly observable and objective probability.
Q: 4
Are all information cost free under non-ideal conditions and how do investors
evaluate if they require more information or not?
Under non-ideal conditions, information is not cost free because each investor has
his/her own subjective estimates and requires different sets of information in
order to make decisions.
Investors do cost benefit analysis and determine if they will acquire more
information. If the cost of information acquired out weight the benefits obtained
by that information then investor does not spend to acquire more information.
Solution:
Q: 5
Solution:
Do investors have same decision with new available information?
No, investors do not have same decision with new available information. As we
know the decision theory does not guarantee that investors will have same
decision. Investors new decision will differ based on prior beliefs and might have
one or more inputs that are different. For example, investor may misidentify one
or more probabilities required by Bayes’ theorem.
Q: 6
Solution:
What is a Capital Asset Pricing Model?
Capital Asset Pricing Model explains the relationship between market price of
security, its risk, and the expected rate of return on a security. CAPM relationship
is shown by following equation: E (Rjt) = Rf + Bj [E (Rmt) – Rf] where Rf is rate of
return on risk free asset such as T-bills, Bj is the beta of security j, and Rmt is the
return on the market portfolio for period t. CAPM relationship is based on some
assumption such as investors are risk adverse, all the information is publicly
known and available.
Q: 7
Solution:
What are the two types of risk faced by investors? Explain?
Two types of risk are market and non-market risk.
Non-market risks are firm specific and these are related to specific firm and its
stock price. Non-market risk can be eliminated by diversification.
Market risks are economy wide risks, which cannot be eliminated, and this will
affect all firms. For example, September 11, 2001 was market risk and this
affected all the firms and stock prices decreased drastically.
Q: 8
Solution:
Are fully informative share prices in the best interest of the accounting
profession? Why or Why not.
Fully informative share prices are not in the best interest of the accounting
profession. If securities prices were fully informative, investors would be able to
make rational buy/sell decisions based solely on the price of securities. They
would not require any additional sources of information. Hence, financial
statements, being an additional source of information, would become useless, and
the demand for accountants would diminish.
Q: 9
Solution:
Describe the “lemons” phenomenon with respect to securities markets.
Because of adverse selection, investors would recognize that the securities market
is not a level playing field, and would either withdraw from the market, or lower
the amount they are willing to pay for any security. Thus, firms with high quality
investment projects will not receive a high price for their securities.
Q: 10
How does the behaviour of investors ensure the continued usefulness of financial
statements?
Some investors can be classified as liquidity traders or noise traders. Their
buy/sell decisions will affect a security’s market price. Their decisions come at
random—they will buy and sell for a variety of unpredictable reasons. These
investors exist alongside rational investors. As a result, security prices are not
fully informative. While some information about firms can be derived from its
security price, financial statements are a useful source of additional information
for rational investors to continue to make rational buy/sell decisions.
Solution:
Q: 11
Solution:
Explain in detail the four implications of efficient securities markets for financial
reporting.
The first implication is accounting policies adopted by firms don’t affect their
security prices, as long as policies are disclosed, have no differential CF effects,
and information is given so readers can easily convert across policies. The policy
that is chosen will affect the reported net income, but it won’t directly affect
future cash flows and dividends. The efficient market is not “fooled” by different
accounting policies when securities of firms are compared. Full disclosure
includes the disclosure of firm accounting policies.
The second implication is that efficient securities markets go hand in hand with
full disclosure. Management should report firm information if the benefits are
greater than the costs. Investors use information to improve decisions in market
efficiency. Confidence in the securities market will increase because of the
information available.
The next implication is that market efficiency implies financial statement
Information doesn’t need to be presented in an elementary form for everyone to
understand. Investors who understand are the ones who buy and sell, therefore
moving market prices to an efficient level. Naïve investors are price-protected, as
they can trust the efficient market to price securities.
Finally, accountants are in competition with other information providers.
Revisions of beliefs are a continuous process. If accountants didn’t provide
useful, cost-effective information, the usefulness of this function would decline to
other information sources. Accounting information is generally useful to
investors.
Q: 12
Solution:
What are the two standards of full disclosure discussed in Chapter 4? Discuss
who governs them, who is required to adhere to them, and what their main
objective is.
The two standards of full disclosure discussed in Chapter 4 are Management
Discussion and Analysis (MD&A) and Future-Oriented Financial Information
(FOFI).
MD&A is governed by Statement 5.10 and the Ontario Securities Commission
(OSC). Relatively large firms (i.e. those with shareholder’s equity and revenues
greater than $10 million) are required to adhere to MD&A’s disclosure
requirements. The main objective of MD&A is to “enhance investor
understanding of the issuer’s business by providing supplemental analysis and
background material to allow a fuller understanding of the nature of an issuer, its
operations and known prospects for the future”.
FOFI is governed by Section 4250 of the CICA Handbook. FOFI is not a
requirement for any firm, however, its presentation can be used as a means to
increase investors’ confidence in a firm through the disclosure of useful
information in a timely manner. The main objective of FOFI is to “provide
external users with information that assists them in evaluating any entity’s
financial prospects”.