Financial accounting theory 5e scot ch04

Chapter 4
Efficient Securities Markets

Copyright © 2009 by Pearson Education Canada

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Chapter 4
Efficient Securities Markets

Copyright © 2009 by Pearson Education Canada

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4.5 Share Price on an Efficient
Market
• CAPM
E(Rjt) = Rf(1 - βj) + βjE(RMt)
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 is ß j

– How is expected return defined? See Equation
(4.2) in text:

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4.2 Efficient Securities Markets
• Definition (Semi-strong form)
–
–
–
–

At all times…
Fully reflect...
All publicly available information…
A relative concept
• Efficiency defined relative to a stock of publicly available
information

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4.3 Accounting Implications of
Securities Market Efficiency
• W. Beaver, “What Should Be the FASB’s
Objectives,” Journal of Accountancy (1973)
– Full disclosure, incl. acc. policies
– Accounting policies do not matter (unless cash flow
effects)
– “Naïve” investors price-protected
– Accountants in competition with other information

providers

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How Does Accounting Information
Affect Share Price?
•

In Equation (4.2), 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 of Equation 4.2 to keep (Ejt)
unchanged

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The Informativeness of Share Price I
• Fully informative share prices
– No one 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
– Hence the logical inconsistency

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The Informativeness of Share Price II

• A way out of the logical inconsistency
– Noise trading
• Expected value of noise = 0
• Share prices still efficient, but in an expected value sense

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The Informativeness of Share Price III
• Partially informative share prices
– Share prices not fully informative since market price
may be “wrong” in presence of noise
– Share prices now only partially reflect publicly available
information—they also reflect noise
– Investors now have incentive to gather information

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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 all
information 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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4.6 Information Asymmetry (continued)
• 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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4.6 Information Asymmetry (continued)

• Effect of estimation risk on share prices
– Efficient market price includes a “discount” for
estimation risk
• i.e., investors demand a higher return

– CAPM overstates cost of capital, since ignores
estimation risk

» Continued

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4.6 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?
• Markets that “work 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)

»

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Continued

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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 main
diagonal probabilities

– More relevant than historical cost-based financial
statements. Less reliable?
– Reasonably consistent with decision theory

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