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AF5102
Accounting Theory
Lecture 3
Efficient Securities Markets
Dr. Zhang Yong
Email:
[email protected] Office: M1042
Efficient Securities Markets
(Bachelier 1900, Samuelson 1965, Fama 1970)
Prices “fully” reflect all
available information
• Price follows random walk
• No risk-free profit opportunities
• Fair game.
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How Do Prices “Fully” Reflect Information
• All investors are rational
• The power of averaging
• Individual investors may react to information with random
errors
• These errors will cancel out in aggregation
• The force of arbitrage
• Informed traders are able to identify mispricing
• Their trading will drive prices towards fundamental value
Analyst Forecasts of FY2009 EPS
Company Name N Mean Stdev Max Min Actual Error
HEWLETT-PACKARD 20 3.84 0.17 4.02 3.31 3.85 0.01
MCDONALDS 21 3.97 0.02 4 3.92 3.98 0.01
MOTOROLA 28 0.02 0.02 0.04 -0.03 0.02 0.00
MICROSOFT 23 1.71 0.03 1.75 1.65 1.7 -0.01
NASDAQ OMX GROUP 20 1.82 0.03 1.86 1.77 1.83 0.01
ORACLE 27 1.45 0.05 1.54 1.37 1.44 -0.01
PFIZER 20 2.03 0.02 2.08 2 2.02 -0.01
WAL-MART 23 3.43 0.04 3.56 3.36 3.42 -0.01
YAHOO! 27 0.42 0.02 0.48 0.33 0.42 0.00
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Three Forms of Market Efficiency
• E. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work”.
The Journal of Finance (1970)
• Weak form
• Prices fully reflect information in historical prices
• Semi-strong form
• Prices fully reflect all public information
• Strong form
• Prices fully reflect all private and public information
Efficiency is a theoretical ideal (and useful conceptual benchmark)
Depending on the circumstances, different markets have different
levels of efficiency – exactly how efficient is each market is an
empirical question that requires careful analyses
The basics –
Practical implication of market efficiency
• There is no free lunch.
• There are rarely low-hanging fruits – unless you have some sort of
special ability or knowledge (or information).
The fundamental idea is to respect the intelligence of others (especially
that of investment professionals) as a group.
o Again, the force of arbitrage.
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More sophisticated thinking – Lee (2001 JAE)
I submit that moving from the mechanics of arbitrage to the
EMH involves an enormous leap of faith. It is akin to believing that the
ocean is flat, simply because we have observed the forces of gravity at
work on a glass of water. No one questions the effect of gravity, or the
fact that water is always seeking its own level. But it is a stretch to infer
from this observation that oceans should look like millponds on a still
summer night. If oceans were flat, how do we explain predictable
patterns, such as tides and currents? How can we account for the
existence of waves, and of surfers? More to the point, if we are in the
business of training surfers, does it make sense to begin by assuming
that waves, in theory, do not exist?
Lee (2001 JAE), cont’d
A more measured, and more descriptive, statement is that
the ocean is constantly trying to become flat. In reality, market prices
are buffeted by a continuous flow of information, or rumors and
innuendos disguised as information. Individuals reacting to these
signals, or pseudo-signals, cannot fully calibrate the extent to which
their own signal is already reflected in price. Prices move as they
trade on the basis of their imperfect informational endowments.
Eventually, through trial and error, the aggregation process is
completed and prices adjust to fully reveal the impact of a particular
signal. But by that time, many new signals have arrived, causing new
turbulence. As a result, the ocean is in a constant state of
restlessness. The market is in a continuous state of adjustment.
In this analogy, market efficiency is a journey, not a destination.
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Implications of Market Efficiency for
Financial Reporting
• William Beaver, “What Should Be the FASB’s
Objectives,” Journal of Accountancy (1973)
Under the ideal situation:
• Accounting policies do not matter (unless have cash flow
effects)
• Full disclosure
• Don’t worry about “naïve” investors – they are price-
protected
• Accountants in competition with other information providers
Capital Asset Pricing Model (CAPM)
• Lintner (1965) and Sharpe (1964)
• Assumptions
• Risk averse, utility-maximizing investors
• Investors care only about mean and variance
• Single-period horizon
• Homogeneous expectations among investors
• Perfect markets
• Investors can’t affect prices
• No taxes
• No transactions costs
• Unlimited borrowing and lending at risk-free rate
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CAPM: Does it work?
E. Fama and K. French
“The Cross-Section of Expected Stock Returns”
The Journal of Finance (1992)
• How to measure expected return on the market
portfolio?
• How to estimate β?
• Market efficiency ≠ CAPM
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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 (vs. public information)
• Information about the firm that is not publicly available
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Information Asymmetry (continued)
• Investor reaction to inside information
• Inside information adds another source of investor
estimation risk
• The lemons problem (Akerlof (1970))
• Would you buy a used car from someone you do not know?
• If so, how much would you pay?
• Would you buy a share in the presence of inside
information?
• No, withdraw from market, market collapses (e.g., post-Enron, post
2007-08 market meltdowns), or
• Yes, but pay less, to protect against estimation risk
Information Asymmetry (continued)
• Effect of estimation risk on share prices
• Efficient market price includes a “discount” for
expected estimation risk (i.e., for expected losses at the
hands of insider trading)
• In effect, investors demand a higher return
• Then, CAPM may understate cost of capital, since
ignores estimation risk
• To some extent, estimation risk may be diversified away, but,
since outside investors more likely to lose than gain from
insider trading, some discount will remain
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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?
• Definition of markets that “work well”
• Low estimation risk, share prices as close to fundamental value as is cost
effective
Role of Financial Reporting in an Efficient
Market
Financial reporting
makes insider
information public,
resulting prices that
are more informative
and closer to
fundamental value
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The Social Benefits of Efficient Markets
• In a capitalist economy, allocation of scarce capital is accomplished by
market prices
• Firms with productive capital projects should be rewarded with high share prices (low cost of
capital)
• Capital allocation is most efficient if share prices reflect fundamental value
• Society is better off the closer are share prices to fundamental value
• Social role of financial reporting
• Increase publicly available information
• Subject to a cost-benefit constraint
• Social role of financial reporting is enhanced by securities market efficiency
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J. Wurgler. “Financial markets and the allocation of capital”. Journal of Financial
Economics (2000)
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