Mod 03 Efficient Securities Market
Efficient Securities Market: prices properly reflect the collective knowledge and
info processing ability of the investors.

Implications: Direct relationship with full disclosure. Efficiency implies it is the
information content of the disclosure (not the form) that is valued by the market
Once investors acquire info then they will act on this => likely will change their
investment decisions thus changing market price of shares. When a sufficient
number of investors are doing this the market becomes efficient.
Semi-strong form of efficient market: Prices of securities traded on that market
at all times “properly reflect” all that is publicly known about these securities.
(1) Market prices are efficient with respect to publicly known info.
Therefore price does not include inside information.
(2) Market efficiency is a relative concept --> efficient relative to a stock of publicly
known info.
Therefore prices could be wrong if insiders are taking advantage of their inside
knowledge to earn excess profits.
Note that once new or corrected information becomes publicly available then market
price adjusts quickly to incorporate this information --> rational investors revise their
beliefs about expected returns and risk of investment.
(3) Investing is a fair game if the market is efficient (price of security is just as likely
to go up as down, over time).
Info that is expected will be properly reflected in price as soon as expectation is
formed. Prices will change only if some relevant, but unexpected info occurs; these
unexpected events occur randomly.
Def’n -> random walk: a time series of a sequence of prices for a given security which
fluctuates randomly over time
Beaver study of the football forecasting - consensus forecast outperformed every one
of the forecasters. It appears that the various errors made by the individual
forecasters tend to cancel out in the consensus.
For this finding to carry over to the security market; investors’ estimates of security
values must, on average, be unbiased (i.e. rational expectations).
Rational expectations: market puts a value on securities that are, on average,
correct or unbiased (does not systematically misinterpret valuation implications).
Market price has superior quality compared to the quality of info processing done by
the individuals that trade on the market. (Investor differences will usually average
out ...therefore important to have a sufficient number of investors in the market)
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Mod 03 Efficient Securities Market
Implications of Efficient Securities Market for financial accounting
From Beaver’s arguments:
1. ACCOUNTING POLICIES ADOPTED BY FIRMS
As long as:
* the firm’s policies have no differential cash flow effects
* particular policies used are disclosed and
* sufficient info is provided that the reader can convert across
different policies
then there will be no effect on share prices.
(Mgmt should not care which accounting policies they use as long as cash flow is not
affected)
2. EFFICIENT MARKETS GO HAND IN HAND WITH FULL DISCLOSURE
 market efficiency implies that investors will use all available info to calculate
expected returns
 more info a firm publishes about itself, the more info is publicly available about
the firm
 if firm possesses relevant info about firm which can be disclosed at little or no
cost, it should be disclosed (unless already known to investors from other sources);
also mgmt should develop and report info about the firm as long as benefits exceed
costs.
BENEFITS of full disclosure:
 enables investors to make better decisions
 improves the ability of security markets to direct investment to most productive
uses
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
FIRMS SHOULD NOT BE CONCERNED ABOUT THE NAIVE INVESTOR
If enough investors understand the disclosed info, this is the same as if all
investors understood ----> informed investors engage in buy & sell activities
which moves the market price to its efficient level.
 Naive investors can hire professionals
 Naive investors can mimic buy/sell decisions of more knowledgeable investors
Any info advantage informed investors may have is quickly dissipated .’. naive
investors can trust efficient market to price securities so that they always reflect
what is publicly know about them (price-protected by efficient market)
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

BELIEF REVISION IS A CONTINUOUS PROCESS
Accountants are in competition with other sources of info
Efficient market is interested in relevant info from any source
Informativeness of price
Inconsistency in that: if market prices reflect all publicly available info then no
motivation for investors to acquire info.
Potentially serious implications for accounting theory:
 difficult to determine if F/S info is useful to investors
 failure of investors to use new info is contrary to what has been observed
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Mod 03 Efficient Securities Market
Inconsistency can be explained due to the fact that there are other sources of
demand and supply for securities other than the buy/sell decisions of rational
investors:
 securities may be bought or sold for many unpredictable reasons (retire early,
need money to pay off debts, etc) ----> liquidity or noise traders
Note: decisions of liquidity/noise traders affects a security’s price but decision is not
based on a rational evaluation of relevant info
Since the presence of noise traders means that market price is no longer fully
informative then investors have an incentive to gather info (market prices are
partially informative and to extent that buy/sell decisions are being made by rational
investors this pushes the prices towards fully reflecting available info .....investors
derive some info about future returns from prices but need to gather further info)
Extent to which investors gather further info depends on:
 informative value of price
 quality of F/S info
 cost of analysis & interpretation
We would expect price will be more informative for large firms since they are in the
media more often - security prices would then respond less to F/S info for large firms
than for small firms
Security prices fully reflect available info up to the level of informativeness that is
allowed by liquidity/noise traders. ( price is partially informative)
CAPM (capital asset pricing model)
Capital asset pricing model is used to:
 improve understanding of the effect of risk and investor expectations on share
price
 enable a separation of realized return on a share into expected and unexpected
components
Ex ante - looking forward from the beginning of period t to calculate an expected return
Ex post - at end of period t and calculating actual return
Sharpe Lintner CAPM
Assume:


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there is a risk-free asset in economy with return Rf
security markets are efficient
transactions costs are zero
Ex ante
E(Rjt) = Rf (1-ß j) + ßjE(Rmt)
Ex poste
Rjt = (j + ßj(Rmt) + jt
where ß is beta
Expected return Unexpected (abnormal) return
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Mod 03 Efficient Securities Market
Main uses for CAPM formula:
1. illustrates how share prices depend upon investors’ expectations of rate of return
E(Rjt) = expected market price at end of t + expected div paid during t
-1
market price at beg of t
(this is the same as the ex ante, links this format back to the approach we are used
to seeing under investor calculations of investments, links to the mod 4 calc of
expected market return.)
2. by using ex post returns CAPM provides a method to separate realized return into
expected and unexpected components
Market model
Rjt = (j + ßj(Rmt) + jt
3. market model provides a convenient method to estimate a stock’s beta
Assumptions for market model formula:
 Beta is known and it is stationary (i.e. doesn’t change)
 There is no inside information
To the extent that beta changes and there is inside information this adds risk ->
referred to as estimation risk. Investor knows there is some risk and that firm’s
actual cost of capital will be higher than the CAPM estimate due to this estimation
risk, so the investors will add on an additional required return to compensate them
for this.
Information asymmetry
Def’n - one type of participant in the market will know something about the asset
being traded that another type of participant does not know.
Effect: hampers the proper operation of security markets.
Adverse selection: insiders will know more than outsiders about the true quality of
the firm and have the opportunity to make excess profits by using this
knowledge...unethical insiders would be attracted by this opportunity. Since
investors would be aware of this then they are motivated to pay less for these
shares.
Financial reporting can help reduce adverse selection problem by:
 adopting policy of full disclosure -> expands set of info that is publicly available
 increase timeliness of reporting -> reduces length of time for insiders to profit
from their information advantage
 increase accuracy of reporting by increasing relevance & reliability
However, this is costly, so unlikely that the problem of inside information can be
completely eliminated.
To the extent that there is full, timely and accurate reporting this increases the
usefulness of financial reporting to investors by improving the quality of the publicly
available information.
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Mod 03 Efficient Securities Market
Since the efficient securities market theory deals with all publicly known information,
it still allows for insider information and information asymmetry. This is a source of
estimation risk, and provides an opportunity to use full disclosure as a way to help
investors to learn some of this inside information.
Social Significance of properly working securities market
It is socially desirable that the markets work properly so that security prices provide
correct prices to allocate capital to the most productive investments. Investment
capital is in short supply so “social welfare will be enhanced if scarce capital goes to
the most productive alternatives”.
Penalties - various provincial securities commissions create & enforce regulations
Incentives -firms with high quality investment projects can credibly communicate
incentive to the market, thus increasing the market price of their shares
Full disclosure - firms have an incentive to fully disclose information in their
financial reports. By building up a reputation for full & fair disclosure, investors are
more willing to pay prices for their shares that reflect underlying value.
Social benefits of properly working securities markets will be met if:
 all relevant information is in the public domain
 security market prices are efficient relative to this information
Full disclosure reduces estimation risk. Thus - investor confidence in securities
markets is increased and share prices more closely reflect the underlying value of
the company (improves investor decisions) => creates social benefits of better
allocation of scarce capital in the economy.
Examples of full disclosure
MD&A and FOFI accounting standards:
 help firms increase the quality of their financial disclosure
 are designed to increase relevance of financial information
Both standards have the potential to provide more info than that found in historical
F/S)
MD & A - required by Ontario Securities Commission for firms which must adhere to
OSC policy statement 5.10
Objective is to assist user in assessing future prospects for firm; also to help
interpret the financial statements in general
 recognizes that there are “practical constraints” on the amount of information in
the historical F/S; therefore additional disclosure and analysis beyond the F/S is
necessary to help investor assessment.
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Mod 03 Efficient Securities Market
Policy statement has some provisions which provide some assistance to firms in
recognition of the cost impact:
 small firms don’t have to comply
 if firm’s securities are also traded in the US then the MD&A reports prepared for
SEC are also acceptable for the OSC
 only need to include MD&A information that is available without “undue effort or
expense” and not easily evident in F/S
 specific auditor involvement in MD&A is not required
 don’t have to disclose information which could put them at a competitive
disadvantage
FOFI (otherwise known as future oriented financial information)
 considered to be a major extension of the full disclosure principle
 objective is to provide users with information that helps them evaluate firm’s
financial
prospects
 applies to both forecasts and projections
forecast - uses assumptions that reflect the firm’s planned course of action for the
time period covered by the FOFI

voluntary standard and applies only if firms decide to release FOFI. (incentive
mechanism for those firms that want to develop or maintain a reputation for full
disclosure)
further to forecasts:
Assumptions should be reasonable and supportable and reflect the most probable
economic conditions (“most probable” requirement is similar to the expected value
approach to decision making under conditions of uncertainty)
Also, time period covered by FOFI should only cover the time that information can be
reasonably estimated.
benefits
estimates
- shorter time period should mean less frequent & material revisions to
- discounting not necessary and choice of discount rate not required
FOFI disclosures are important since they provide a link between past & future
performance (therefore relevant) and doesn’t compromise the integrity (i.e.
reliability) of the F/S.
Voluntary nature of FOFI provides a indirect signal to the market. Willingness to
forecast suggests mgmt is looking forward to a successful future.
CALCULATIONS TO KNOW:
 Ex Ante calculation of expected return (E(Rjt)
Ex Poste calculation of actual return Rjt (be able to calculate abnormal return)
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