chapter 4_acc theory

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Indra Pratama/ Accounting / Bachelor / Accounting Theory

S W I S S G E R M A N U N I V E R S I T Y

April 13, 2011

QF 7.01/REV01

1

CHAPTER 4

Efficient Security Market





April 13, 2011

Chapter 4

Efficient Securities Markets





April 13, 2011

4.2 Efficient Securities MarketsDefinition (Semi-strong form)

� Efficient Securities Market is one where the prices of securitiestraded on the market at all times fully reflect all information that is

publicly known about the information

� 3 Important aspects

± All publicly available information

± A relative concept

� Efficiency defined relative to a stock of publicly available

information ± Fair Game





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4.3 Accounting Implications of SecuritiesMarket Efficiency� W. Beaver, ³What Should Be the FASB¶s Objectives,´ Journal of

Accountancy (1973)

± Full disclosure, incl. acc. policies

± Accounting policies do not matter (unless cash flow effects)

± ³Naïve´ investors price-protected

± Accountants in competition with other information providers





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4.4 The informativeness of priceFully informative share prices

No one would bother to gather information, since can¶t beat themarket

If no one gathers information, share prices will not reflect all publicly available information

Hence the logical inconsistencyPartially informative share prices

Share prices not fully informative since market price may be ³wrong´ in presence of noise

Share prices now only partially reflect publicly availableinformation²they also reflect noise

Investors now have incentive to gather information





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4.5 Share Price on an Efficient Market

� CAPM

E(R jt

) = R f

(1 - j

) + j

E(R Mt

)

Market sets share price so that expected

return E(R jt) (i.e., firm¶s cost of

capital) is given by right side of equation

Note that only firm-specific component isß j





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4.5 Capital Asset Pricing Model (CAPM)

E(Rjt) = Rf(1 - j) + jE(RMt) OR

E(Rjt) = Rf + j (E(RMt) ± Rf)

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

A model that shown the relationship between the efficient

market price of a security , its risk , and the expected rate of

return on a security.





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4.6 Information Asymmetry� The fundamental value of a share

± The value of a firm¶s share on an efficient market if allinformation about the firm is publicly available (i.e., no inside

information)

� Inside information

± Information about the firm that is not publicly available

» Continued





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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





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� 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





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� Effect of estimation risk on share prices

± Efficient market price includes a ³discount´ for estimation risk

� i.e., investors demand a higher return ± CAPM overstates cost of capital, since ignores estimation risk

» Continued





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� Controlling estimation risk

± Insider trading laws

± Financial reporting

� Role of financial reporting is to convert inside informationinto outside, thereby reducing estimation risk

� Cannot eliminate all inside information. Why?

� Markets that ³work well´

± Low estimation risk, share prices as close to fundamental value as

is cost effective





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A Graphical Illustration of Estimation Risk





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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





April 13, 2011

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





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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 maindiagonal probabilities

± More relevant than historical cost-based financial statements.Less reliable?

± Reasonably consistent with decision theory





April 13, 2011

End of Chapter 4

chapter 4_acc theory

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