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Efficient Securities Markets

Efficient Securities Markets. BU427 – March 14 th , 2011 Andrew Baer, Peter Hanna, Kyle Lambert and Josh Ritter. Outline. 4.1 Overview 4.2 Efficient Securities Markets 4.3 Implications of Efficient Securities Markets 4.4 Informativeness of Price 4.5 Capital Asset Pricing Model

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Efficient Securities Markets

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  1. Efficient Securities Markets BU427 – March 14th, 2011 Andrew Baer, Peter Hanna, Kyle Lambert and Josh Ritter

  2. Outline • 4.1 Overview • 4.2 Efficient Securities Markets • 4.3 Implications of Efficient Securities Markets • 4.4 Informativeness of Price • 4.5 Capital Asset Pricing Model • 4.6 Information Asymmetry • 4.7 Social Significance • 4.8 Example of Full Disclosure • 4.9 Conclusions

  3. 4.2 – Efficient Securities Markets

  4. Efficient Securities Markets What is an efficient market? “An efficient securities market is one where prices of securities traded on that market at all times fully reflect all information that is publicly known about those securities”

  5. Efficient Securities Markets Three things to Consider: Public Information Does not include inside information Relativity Efficiency is relative to company’s public information Fair Game Theory Investors cannot expect to earn excess returns

  6. Reaction to Available Information CLASS EXAMPLE – NHL RESULTS

  7. Reaction to Available Information • Prices will react quickly to new or revised information • Different investors will react to the same information differently • The average market will create a market price that is superior quality to that of the individual investors • Assumption: Investors are evaluating the new information independently

  8. 4.3 - Implications for Financial Reporting

  9. Implications of Efficient Securities for Financial Reporting Accounting Policies No effect on security prices assuming no differential effect on cash flow Full Disclosure Firms should disclose the most information while maintaining a cost-effective approach Additional information will not be wasted

  10. Implications of Efficient Securities for Financial Reporting Naïve/Uninformed Investor Price Protected - efficient security prices fully reflect all that is publicly known Multiple media sources available to receive information without fully understanding it

  11. 4.4 - Informativeness of Price • A logical inconsistency • What is “fully reflects”? Where’s the info? • Price already fully informative by definition • Information acquisition can be expensive • No motivation for investors to seek outside information • Must recognize other sources of security exchanges (retire early, pay gambling debts, etc.) • Noise traders: occurs randomly and not based on the rational evaluation of available information • Imagine 2price increase scenarios; • 1. Information available more favourable to other investors • 2. Increase in price due to noise traders

  12. PARTIALLY INFORMATIVE SECURITIES Essentially, placing of weighted possibilities Investors now have incentive to obtain info Information reveals: Undervalued firm: Buy! High valued firm due to noise trading: Sell Short! Ultimately, returns price to efficient value Security prices are partially informative for noise trading and rational expectations

  13. EXTENT OF INFORMATION Extent of information gathered depends on: How informative the price is Quality of financial statement information Costs of analysis Example: big firms vs small firms Element of voluntary disclosure Rational investor must look at what manager does for accounting policy choice and disclosure Example: firms with secret research program

  14. PWC - UPDATE ON REPORTING STANDARDS FOR THE ADOPTION OF PE-GAAP Top anticipated transition issue: selection of accounting policy choices Many choices to make, ones that will have financial reporting impacts. Enterprises must beware of impacts of choices on: Debt covenants Regulatory requirements The needs of users of the financial statements Any impact on tax calculations Some decisions over FV are time sensitive

  15. Efficiency Summary Take the term “fully reflects” with grain of salt Not fully informative at all points in time Consider tensions between: Level of informativeness allowed by noise traders Analysis of information in F/S to identify misprices securities for investors Supplementary disclosures Choice of accounting policies Nature and extent of voluntary disclosure Improved understanding of process of price information allows accountants to prepare more relevant, reliable, and useful financial statements

  16. 4.5 - Capital Asset Pricing Model

  17. CAPITAL ASSET PRICING MODEL (CAPM) Definition: Formalize the relationship between efficient market price or a security, its risk, and the expected rate of return on a security 3 Equations and examples to be shown: Ex-post ROR (return actually realized during period) Ex-ante ROR (at the beginning of time) Expected return (calculate unknown share price)

  18. REDUCING RISK Greater financial reporting informativeness can reduce Bj reducing cost of capital GE Text example Consequently, the possibility of reducing investor risk by more informative reporting is of interest to us accountants!

  19. 3 MAIN USES Share prices depend on investor`s expectations of future share price and dividends Ex-post view of returns allows for separation of expected and unexpected return components Market model provides a convenient way for researchers and analysts to estimate a stock’s beta.

  20. 4.6 - Information Asymmetry, Insider Trading and Adverse Selection

  21. Information Asymmetry • Definition: • When one participant in the market (seller) knows something about the asset being traded that another type of participant (buyer) does not • Types of Information Asymmetry • Adverse Selection – one or more parties to a business transaction have an information advantage over other parties • Moral Hazard – one or more parties to a business transaction can observe their actions in fulfillment of the transaction but other parties cannot

  22. Insider Trading • Raj Rajaratnam, the hedge fund founder of Galleon could face up to a 20 year prison sentence • Since October 2009 the U.S. Government has commenced the biggest probe of insider trading into the 1.9 trillion hedge fund industry • 26 individuals have been charged, 19 have pleaded guilty • Rajat Gupta, former Goldman board member is also being accused of tipping off Rajaratnam • http://www.bloomberg.com/video/67410902/

  23. Efficient Market Price Role of Financial Reporting Publicly Available Information Fundamental Value Inside Information

  24. 4.7 – SOCIAL SIGNIFICANCE OF SECURITIES MARKETS THAT “WORK WELL” • Social welfare improved if capital goes to the most productive alternatives • If the market is not working well it may lose depth • Depth - The number of shares that investors can buy or sell without affecting the market price • Low of depth decreases the amount of shares investors can buy or sell which hampers investment • Wurgler investigated markets that work well • Countries with more firm specific information incorporated into their share prices have greater capital allocation efficiency

  25. IMPROVING MARKETS • Regulation • Enforce regulations to control insider trading • Promote prompt disclosure • Penalize violations • Incentives • Higher sales prices • Lower cost of capital • Reduces investor’s concerns of insider trading

  26. 4.8 – an example of full disclosure

  27. An Example of Full Disclosure • Why Full Disclosure • Best interest of companies - Trust • Standards to follow • Most Frequently Used • Management Discussion and Analysis (MD&A) • Found in Annual Report

  28. An Example of Full Disclosure • Management Discussion and Analysis (MD&A) • Requires companies to provide a narrative of • Company performance • Financial condition • Future prospects • Intentions • Assist investors to interpret financial statements • Practical example of how information accessible to the public can be increased

  29. An Example of Full Disclosure • Key Points of MD&A • Required • Amount of information is flexible • Ranges between restating financial statements and releasing inside information • Regulations can be found in National Instrument 51-102 of the Ontario Securities Commission (OSC) • Applied across Canada by the Canadian Securities Administration • Similar requirements are found in the United States through the Securities and Exchange Commission (SEC) • To be written in language investors will understand

  30. An Example of Full Disclosure • Objectives of MD&A • To help current and potential investors understand financial statements • To discuss information not available in financial statements • To discuss trends and risks • To help investors decide if past performance is a good indication of future performance

  31. An Example of Full Disclosure • Specific Requirements of MD&A • Discuss overall firm performance • Explain factors causing variations • Indicate the set of accounting principles used • Discuss the firm’s ability to meet short and long term liquidity needs • Discuss important commitments • Discuss any changes in accounting policy • Explain performance affected by trends and risks • Describe financial instruments used to manage risks

  32. An Example of Full Disclosure • Notable Aspects of MD&A • Forward looking • Specifies the relationship between current financial statements and future performance • Favours relevance over reliability (emphasis on timing)

  33. An Example of Full Disclosure • Relevance of MD&A • Encourages full disclosure • Forward-looking information • Discusses industry risks • Helps investors reduce estimation risk

  34. An Example of Full Disclosure • Refer to pg 122 for Canadian Tire award winning example of MD&A

  35. An Example of Full Disclosure • Babcock & Wilcox Canada

  36. An Example of Full Disclosure • Risks: • Potential for lawsuits • Loss of investors trust when plans not met • Benefits: • Reduce estimation risk • Lowers cost of capital • Potential to boost investor confidence

  37. 4.9 – Summary/Conclusion • Efficiency is relative to a stock’s publicly known information • Financial reporting plays a role in improving the amount, timing and accuracy of the stock’s information • Going beyond minimal reporting shows confidence • Noise, liquidity traders and insider trade ensure that investors take the time and effort to collect information

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