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Chapter 4

Chapter 4. Efficient Securities Markets. Chapter 4 Efficient Securities Markets. 4.5 Share Price on an Efficient Market. CAPM E(R jt ) = R f (1 - β j ) + β j E(R Mt )

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Chapter 4

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  1. Chapter 4 Efficient Securities Markets

  2. Chapter 4 Efficient Securities Markets

  3. 4.5 Share Price on an Efficient Market • CAPM • E(Rjt) = Rf(1 - βj) + βjE(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:

  4. 4.2 Efficient Securities Markets • Definition (Semi-strong form) • At all times… • Fully reflect... • All publicly available information… • A relative concept • Efficiency defined relative to a stock of publicly available information

  5. 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

  6. 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 4.2to keep(Ejt) unchanged

  7. The Informativeness of Share Price I • Fully informative share prices • No one would bother to gather information, since can’t beat the market • If no one gathers information, share prices will not reflect all publicly available information • Hence the logical inconsistency

  8. The Informativeness of Share Price II • A way out of the logical inconsistency • Noise trading • Expected value of noise = 0 • Share prices still efficient, but in an expected value sense

  9. The Informativeness of Share Price III • Partially informative share prices • Share prices not fully informative since market price may be “wrong” in presence of noise • Share prices now only partially reflect publicly available information—they also reflect noise • Investors now have incentive to gather information

  10. 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

  11. 4.6 Information Asymmetry (continued) • The adverse selection problem • Insiders may exploit their information advantage to earn profits at the expense of outside investors • Inside information a source of estimation risk for investors • Continued

  12. 4.6 Information Asymmetry (continued) • Investor reaction to estimation risk • The lemons problem (Akerlof (1970)) • Would you buy a used car from someone you do not know? • Would you buy a share in the presence of inside information? • No, withdraw from market, market collapses (e.g., post-Enron) • Yes, but pay less, to protect against estimation risk • Note: estimation risk cannot be diversified away. Why? • Continued

  13. 4.6 Information Asymmetry (continued) • Effect of estimation risk on share prices • Efficient market price includes a “discount” for estimation risk • i.e., investors demand a higher return • CAPM overstates cost of capital, since ignores estimation risk • Continued

  14. 4.6 Information Asymmetry (continued) • 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? • Markets that “work well” • Low estimation risk, share prices as close to fundamental value as is cost effective

  15. A Graphical Illustration of Estimation Risk

  16. 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

  17. 4.7 Social Significance of Markets that 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 • Requires securities market efficiency

  18. 4.8 An Example of Full Disclosure • Management Discussion and Analysis • Forward-looking orientation • Concept of information system is implicit • Forward orientation and risk information increase main diagonal probabilities • More relevant than historical cost-based financial statements. Less reliable? • Reasonably consistent with decision theory

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