Chapter 4

Efficient Securities Markets

Agenda
— Efficient securities market
— Informativeness of stock price
— CAPM
— Information asymmetry in securities
markets
— Social significance of securities market
Efficient Securities Markets
— Definition of market efficiency
◦ Semi-strong form: An efficient securities
market is one where the prices of securities
traded on that market at all times fully reflect
all information is publicly known about those
securities.
◦ Strong form: securities prices reflect all
information.
Efficient Securities Markets
— Key points about efficiency
◦ “public known” information
◦ A relative concept
◦ Investing is a fair game.
◦ Stock price should fluctuate randomly over
time (random walk, no serial correlation).
 Efficient Securities Markets
• A market is efficient with respect to information
set qt if it is impossible to make economic profits
by trading on the basis of information set qt.
v Weak form: qt contains only past security prices
and/or past trading volume.
v Semi-strong form: qt contains all published information
at time t.
v Strong form: qt includes all information known to
anyone at time t (e.g., the management’s future
investment production plans, pricing policies).
Efficient Securities Markets
— Different rational investors react to the
same information differently.
— Investors’ estimates of security values
must be unbiased on average.
— Individual decisions are independent, so
that individual differences cancel out in
their effect on price.
 Implications for Financial Reporting
— W. H. Beaver (1973), “What Should Be the
FASB’s Objectives”, Journal of Accountancy
◦ Accounting policies do not matter, as long as
policies have no cash flow effects and sufficient
information is disclosed to investors.
◦ Full disclosure (cost-benefit)
◦ Naïve investors being price-protected by the
efficient market
◦ Accountants in competition with other
information providers
 The informativeness of Price
— Fully informative share prices
◦ If share prices are fully informative, none 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.
◦ If share prices do not reflect all publicly available
information, investors will gather information.
◦ Share price will quickly become fully informative
◦ Then, none would bother to gather information, etc.,
etc.
 The informativeness of Price
— Noise trading and partially informative prices
◦ Their buy/sell decisions come at random.
◦ Rational investors have expectations on noise
trading.
◦ Partially informative: Given that the expected value
of noise is zero, market prices are efficient in an
expected value sense.
◦ Investors still have incentive to gather information.
◦ Financial reporting is still useful to investors.
 CAPM
— Assumptions
v The rates of return on assets have distributions that
can be fully described by the expected rate of return
E(Rj) and some measure of dispersion such as the
variance s2(Rj). Alternatively, the preferences of
individuals are such that E(Rj) and s2(Rj) are the only
parameters of the distribution of rates of return that
are of interest to those individuals.
v Markets are perfect.
v Investors are rational and risk averse and maximize
their expected utility of consumption.
v Investors assume that other individuals also act
rationally.
CAPM
v All Individuals in the market have the same costless
access to information and hold the same views of
expected rates of returns on assets and of the
variances of those returns. That is, the investors have
homogeneous beliefs.
v There exists a riskless asset f (that is, s2(Rf) = 0) and
all individuals can borrow and lend at the riskless
rate Rf.
CAPM
• Capital markets are perfect:
◦ No individual borrower or lender in the
capital market is wealthy enough to have an
effect on market interest rates (no one
individual can influence the market price of
funds). Each individual can borrow or lend up
to the limit of his or her resources at the
market rate of interest.
◦ Information is free, costless, and available to
everyone.
◦ There are no transaction costs or taxes.
◦ All assets are infinitely divisible.
CAPM
— An investor in the asset j earns a realized
rate of return
Pjt + D jt - Pj ,t -1 Pjt + D jt
R jt = = -1
Pj ,t -1 Pj ,t -1

— Expected return
E ( Pjt + D jt )
E ( R jt ) = -1
Pj ,t -1
 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
Cov ( R j , RM )
bj =
Var ( RM )
CAPM
— How does accounting information affect
share price?
◦ 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 to keep E(Rjt)
unchanged
 CAPM
— CAPM can be written as:
[
E (R jt ) = R f + b j E (RMt ) - R f ]
The risk premium
b j [E (RMt ) - R f ]

The level of risk, The price per unit of

which varies risk, which is the same
across assets for all assets.
 CAPM
— Market model (ex post view)
Rjt=αj+βjRMt+εjt
where αj=Rf(1-βj), εjt is the unexpected/abnormal return

— Estimation of β
Rjt=Rf+βj (RMt- Rf) +εjt
◦ The coefficient on RMt (estimate of β) captures the “market”
effects that affect the returns of all assets
◦ The disturbance term ejt captures variations that only affect
the rate of return on asset j (Rjt). In other words, ejt is the
abnormal rate of return due to factors specific to the firm,
not to the market portfolio.
CAPM
— CAPM assumes rational expectations,
i.e., investors know betas and the
expected market return.
— Estimation risk
— Information asymmetry between
insiders and outsiders
— Literature on information risk and
disclosure
 CAPM
— If the actual price of assets j at time t is
greater than expected given the information
set qt , that is,
Pjt > E (Pjt | q t ) and R jt > E (R jt | q t )

— We can define abnormal rate of return on

asset j for period t as
AR jt = R jt - E (R jt | q t )
Information Asymmetry
in Securities Market
— 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
Information Asymmetry
in Securities Market
— Investor’s reaction to inside information
◦ Inside information is 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)
– Yes, but pay less, to protect against estimation risk
Information Asymmetry
in Securities Market
— Effect of estimation risk on share prices
◦ Efficient market price includes a “discount” for
estimation risk.
– i.e., investors demand a higher return.
◦ CAPM understates cost of capital, since it
ignores estimation risk.
— Controlling estimation risk
◦ Insider trading laws
◦ Financial reporting, which converts inside
information into public information
Information Asymmetry
in Securities Market
Social Significance of Securities Markets
— In an economy, allocation of scarce capital
to competing demands is accomplished by
securities markets.
◦ 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)
Social Significance of Securities Markets
— Social role of financial reporting
◦ To help markets work well
– Maximize amount of publicly available information
– Subject to a cost-benefit constraint
— Social role of financial reporting is
enhanced if securities markets are
efficient
◦ Then, market fully uses financial accounting
information.
Social Significance of Securities Markets
— Mechanisms for promoting reporting
quality
◦ Regulations: accounting standards, inside
trading laws, and disclosure requirement
◦ Incentives: reputation, higher stock
price, lower cost of capital, investment
efficiency