The Meaning of Efficiency What happen when a large amount of rational investors interacting in a securities market? Characteristics of market prices of securities traded in market How are prices affected by new information?
The Meaning of Efficiency 2 conditions Ideal conditions Information is free Non-ideal conditions Information is not free
The Meaning of Efficiency Investors who spend considerable time and money to use information sources to guide their investment decisions are known as informed Move quickly given the new information Market becomes efficient when a sufficient number of investors behave this way
The Meaning of Efficiency Semi-strong form: An efficient securities market is one where the prices of securities traded on that market at all times fully reflect all information that is publicly known about those securities
The Meaning of Efficiency 4 points about efficiency: 1. Market prices are efficient with respect to publicly known information 2. Market efficiency is a relative concept 3. Investing is a fair game if the market is efficient 4. Given market efficiency, a security’s market price should fluctuate randomly over time
How do Market Prices Fully Reflect all Available Information? Market price of a security is the result of demand and supply of the security by investors Investors are still likely to react differently given the same information The differences average out Assume individual decisions are independent
According to W. H. Beaver, Accounting policies adopted by firms do not affect their security prices If the benefits of disclosing information outweighs its cost, the information should be disclosed
Quick question... DO YOU GUYS AGREE? DO THE POLICIES ADOPTED BY ACCOUNTANTS FOR FINANCIAL STATEMENT PURPOSES MATTER? DOES THIS ARGUMENT BY BEAVER HOLD UP IN REALITY?
Empirical evidence showed... There is in fact no increase in securities prices by changing to an accounting method that increases reported earnings Price-earnings ratio was higher for firms that reported with accelerated methods than those that reported with straight-line methods When reports using one were converted to the other, price-earning ratios were “essentially equal”
According to W. H. Beaver, (cont.) Accountants compete with other information providers (ex: newspapers, websites, management disclosures) Firms don’t need to simplify their financial statements for everybody to understand Investors without the time or knowledge to properly interpret information can look to the informed
Thinking critically... DO YOU AGREE? IS THIS ACCOUNTING’S MAIN ROLE? WHO DO YOU SEE AS COMPETITION FOR THE ACCOUNTING PROFESSION? DOES THIS MAKE SENSE? WOULD INVESTORS HAVE INCENTIVE TO DO RESEARCH IF ADVANTAGES WERE SHORT-LIVED?
The Informativeness of Price A Logical Inconsistency Football Forecasting
The Informativeness of Price Liquidity/ Noise Traders Liquidity/ Noise Traders
The Informativeness of Price – Voluntary Disclosure disclosure of information beyond the minimum requirement of GAAP and other reporting standards Do not want to reveal information that would give away competitive advantage Conservative accounting polices
CAPM R jt Rate of return of stock j during time t R f Rate of return of risk free asset R Mt Rate of return of Market during time t β j Risk associated with stock j
Significance What is the effect of new information? – Ex. If investors believe D jt will be higher then what changes? P j,t-1 must compensate since E(R jt ) is held constant What is the effect of an improved information reporting system? – Allows investors to better predict the future reducing their risk and reducing β – Lowers the firms cost of capital – Industry wide impact
Significance Applying the CAPM Allows investors to identify returns that were not expected at the beginning of the period On average ε is zero CAPM allows researchers to easily estimate β through regression analysis
Estimation Risk Not everyone may have the same belief about β Large differences create volatility High volatility results in risk premiums being demanded Information asymmetry (insider information) If it exists then investors require risk premium
Information Asymmetry When one party in the market knows something about the product being traded that the other party does not The Used Car Market
Pooling Lack of information leads to lowering the price the buyer is willing to pay. Can be tackled by using independent disclosure devices (eg. Safety certificates). Allows the market to operate but not at maximum efficiency.
Fundamental Value The fundamental value of a share is the value it would have in an efficient market if there is no inside information. That is, all information is publicly available. Only a theoretical ideal. Not possible as it can reveal strategic information and is not cost effective.
Securities Market Securities provide the means for capital to be raised for investment needs It is socially desirable for markets to work well.
Socially Desirable? This means that firms prices reflect their fundamental value This is achieved if more useful information is provided to investors, resulting in better capital allocation
Other Implications Firms are sometimes constrained on taking advantage of growth opportunities due to it’s ability to obtain financing. It is easier to obtain financing the higher the quality of financial reporting in their respective country
Attaining Securities Markets that Work Well Issue: Security prices do not fully reflect fundamental value in the presence of inside information Remedies: Regulation Incentives
MD&A Provides a narrative explanation of company operations (financial condition, performance and future prospects.
History Based on the requirements of National Instrument 51- 102 of the OSC in 2004 Was later adopted across Canada and similar requirements exist in other jurisdiction such as the United States.
Question Discuss the advantages and possible disadvantages of additional disclosure requirements such as MD&A.
Objectives Help current/prospective investors understand the financial statements Discuss any information not fully reflected in the financial statements Any trends/risks Provide information about the variability of earnings and cash flow
Disclosure Requirements Discuss firm performance in relation to assets, liabilities and revenue Indicate what accounting principles are used in the financials or if there were any changes Future outlook Relevance/ Reliability tradeoff
MD&A Is a requirement that emphasizes full disclosure Reduces estimation risk due to its forward looking nature Attempts to make the markets work better by disclosing inside information