Key Sources of Financial Information

1. 3 Key Sources of Financial Information C h a p t e r Money and Capital Markets Financial Institutions and Instruments in a Global Marketplace Eighth Edition Peter S. Rose McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

2.  Learning Objectives  • To identify important sources of information about the global financial system. • To understand why the efficient distribution of information within the financial system is important. • To learn how market participants keep track of the prices of financial assets. • To learn about the content and concepts behind the main social accounting systems.

3. Introduction • Sound financial decisions require adequate and accurate financial information. • We may divide the sources of information relied on by financial decision makers into: • debt security prices and yields, • stock prices and dividend yields, • information on security issuers, • general economic and financial conditions, and • social accounting data.

4. Efficient Markets & Asymmetric Information • The efficient markets hypothesis (EMH) contends that information relevant to the pricing (valuation) of loans, securities, and other financial assets is readily available to all borrowers and lenders at negligible cost.

5. Efficient Markets & Asymmetric Information • On the other hand, the concept of asymmetric information argues that the financial marketplace contains pockets of inefficiency in the availability and use of information, such that insiders can earn excess returns by selectively trading assets based on the special information they have been able to acquire.

6. Efficient Markets & Asymmetric Information • In an efficient marketplace, each individual investor will rationally use all the relevant information that is available to value stocks and bonds. • Hence, each financial asset will generate an ordinary or normal rate of return commensurate with its level of risk.

7. Efficient Markets & Asymmetric Information • According to the capital asset pricing model (CAPM), the expected return on financial asset (or portfolio of assets) i, E(Ri), is: • The CAPM indicates that E(Ri) depends on • rF, the time value of money (risk-free interest rate) • E(RM) – rF, the reward for bearing systematic risk • i, asset i’s level of systematic risk

8. E(Ri) SML RM  market portfolio M rF 0 1.0  Efficient Markets & Asymmetric Information • The line or curve described by the CAPM equation is usually called the security market line (SML).

9. Efficient Markets & Asymmetric Information • If the EMH holds, any temporary deviation of actual returns from the SML should be quickly eliminated as investors react to temporary underpricing or overpricing of assets.

10. Different Forms of the EMH • The weak form of the EMH argues that the current price of a financial asset already reflects all its price and trading volume history. • The semistrong form contends that the current price of a financial asset already reflects all publicly available and relevant information. • The strong form argues that the current price of a financial asset already captures all relevant public and private information.

11. Different Forms of the EMH • Repeated research studies have essentially confirmed the weak and semistrong forms of the EMH. • The strong form, however, has been the most controversial, especially because of the existence of insider trading activities and because of the apparent asymmetrical scattering of pockets of special information throughout the financial system.

12. Problems Informational Asymmetries Can Create • Lemons and Plums. A loan officer (buyer) cannot be sure without incurring substantial costs whether his or her potential customer (seller) is a lemon (sour) or plum (sweet). • Result: Plums may be driven away from the market.

13. Problems Informational Asymmetries Can Create • Adverse Selection. A bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its high-balance, low-activity (and hence most profitable) customers. • Solution: Enabling customer signaling via a price schedule for different account plans.

14. Problems Informational Asymmetries Can Create • Moral Hazard. One party to a principal-agent contract may decide to pursue its own self-interest at the expense of the other party. • Solution: Contracts drawn with the appropriate incentives and monitoring.

15. Asymmetry, Efficiency, & Real-World Markets • All real-world markets seem to have elements of both efficiency and asymmetry. • Perhaps, real-world markets can be split into two segments: • A highly efficient segment in which well-informed individuals and institutions trade. • A market segment in which less-well-informed small investors and small businesses trade.

16. Possible Remedies for Informational Asymmetries • Some laws and regulations are designed to improve the flow of information between buyers and sellers and to protect the public against deception in valuing financial assets. • Examples (U.S. ): • 1934 Securities Exchange Act • 1940 Investment Company Act • 1970 Securities Investor Protection Act • Regulation FD (Fair Disclosure), 2000

17. Sources of Information Debt Security Prices and Yields • Data: bid & ask prices, yields-to-maturity Sources: real-time computer networks (e.g. Reuters, Bloomberg), televised reports (e.g. CNN, CNBC), financial press (e.g. The Wall Street Journal) • Data: bond yield indexes Sources: Moody’s Investor Service, The Daily Bond Buyer, U.S. Treasury, Dow Jones

18. Sources of Information Stock Prices and Dividend Yields • Data: prices (year-high, year-low, day-high, day-low, closing), sales volume, most recent dividend, dividend yield, P-E ratio, stock price indexes (e.g. DJIA, S&P500), foreign stock prices Sources: computer networks (e.g. Internet), financial press, television, radio, financial institutions (e.g. S&P, Morningstar)

19. Sources of Information Security Issuers • Data: firm history, principal products/services, key officers, recent operation summary, financial statements, credit ratings, industry performance indicators Sources: regulatory agencies (e.g. SEC), trade associations, commercial institutions (e.g. Moody’s, S&P, Dun & Bradstreet), directories & databases, journals & magazines, credit bureaus

20. Sources of Information General Economic and Financial Conditions • Data: interest rates, money supply measures, industrial output, international transactions, unemployment rate, inflation, forecasts Sources: central banks (e.g. the Federal Reserve), statistical bureaus (e.g. Bureau of Economic Analysis), financial press

21. Social Accounting Data • Social accounting refers to the system of record keeping that reports transactions between the principal sectors of the economy, such as households, financial institutions, corporations, and units of government. • The two most closely followed social accounting systems in the U.S. are the National Income Accounts and the Flow of Funds Accounts.

22. National Income Accounts • The National Income Accounts (NIA) present data on the nation’s production of goods and services, income flows, investment spending, consumption, and savings. • In particular, the level and growth of the nation’s economic activity is summarized by the gross national product (GNP) and gross domestic product (GDP).

23. 3 - 23 National Income Accounts Sample Table from the U.S. National Income and Product Accounts (NIPA) Source: http://www.bea.gov

24. Flow of Funds Accounts • The Flow of Funds Accounts • trace the flow of savings by businesses, households, and governments into purchases of financial assets, • show how the various parts of the financial system interact with each other, and • highlight the interconnections between the financial sector and the rest of the economy.

25. Flow of Funds Accounts • The construction of the Flow of Funds Accounts requires four basic steps: • Sector the economy. • Construct sector balance sheets.

26. 3 - 26 Flow of Funds Accounts Sample Balance Sheet from the U.S. Flow of Funds Accounts Source: http://www.federalreserve.gov

27. Flow of Funds Accounts • The construction of the Flow of Funds Accounts requires four basic steps: • Sector the economy. • Construct sector balance sheets. • Prepare a sources and uses of funds statement for each sector.

28. 3 - 28 Flow of Funds Accounts Sample Sources and Uses of Funds Statement from the U.S. Flow of Funds Accounts Source: http://www.federalreserve.gov

29. Flow of Funds Accounts • The construction of the Flow of Funds Accounts requires four basic steps: • Sector the economy. • Construct sector balance sheets. • Prepare a sources and uses of funds statement for each sector. • Construct a flow of funds matrix for the economy as a whole.

30. 3 - 30 Flow of Funds Accounts Sample U.S. Flow of Funds Matrix Source: http://www.federalreserve.gov

31. Money and Capital Markets in Cyberspace • Most key institutions provide extensive online information. Visit, for example, the Federal Reserve at http://www.federalreserve.gov and the Securities and Exchange Commission at http://www.sec.gov. Or link to worldwide central banks from http://www.bis.org/cbanks.htm. • Many financial institutions have also made it easier to track money and capital market movements. Visit, for example, Money Magazine’s http://money.cnn.com/.

32. Chapter Review • Introduction • Efficient Markets and Asymmetric Information • The Efficient Markets Hypothesis (EMH) • The Security Market Line (SML) • Different Forms of the EMH • Insiders and Insider Trading • The Concept of Asymmetric Information

33. Chapter Review • Efficient Markets and Asymmetric Information … cont • Problems Informational Asymmetries Can Create • Lemons and Plums • Adverse Selection • Moral Hazard • Asymmetry, Efficiency, and Real-World Markets • Possible Remedies for Informational Asymmetries

34. Chapter Review • Sources of Information • Debt Security Prices and Yields • Stock Prices and Dividend Yields • Security Issuers • General Economic and Financial Conditions • Social Accounting Data • National Income Accounts • Flow of Funds Accounts