Efficient Securities Market

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Efficient Securities MarketSheikh AbbasAli DatooWilson ManChirag ShamdasaniHermanraj SinghRachel TamAgendaThe Meaning of EfficiencyWhat happen when a large amount of rational investors interacting in a securities market?Characteristics of market prices of securities traded in marketHow are prices affected by new information?The Meaning of Efficiency2 conditionsIdeal conditionsInformation is freeNon-ideal conditionsInformation is not freeThe Meaning of EfficiencyInvestors who spend considerable time and money to use information sources to guide their investment decisions are known as informedMove quickly given the new informationMarket becomes efficient when a sufficient number of investors behave this wayThe Meaning of EfficiencySemi-strong form: An efficient securities market is one where the prices of securities traded on that market at all times fully reflect all information that is publicly known about those securitiesThe Meaning of Efficiency4 points about efficiency:Market prices are efficient with respect to publicly known information Market efficiency is a relative conceptInvesting is a fair game if the market is efficientGiven market efficiency, a securitys market price should fluctuate randomly over timeHow do Market Prices Fully Reflect all Available Information?Market price of a security is the result of demand and supply of the security by investorsInvestors are still likely to react differently given the same informationThe differences average outAssume individual decisions are independentImplications for financial reportingSection 4.3According to W. H. Beaver,Accounting policies adopted by firms do not affect their security pricesIf the benefits of disclosing information outweighs its cost, the informationshould be disclosed

Quick question...DO YOU GUYS AGREE? DO THE POLICIES ADOPTED BY ACCOUNTANTS FOR FINANCIAL STATEMENT PURPOSES MATTER? DOES THIS ARGUMENT BY BEAVER HOLD UP IN REALITY?Empirical evidence showed...There is in fact no increase in securities prices by changing to an accounting method that increases reported earningsPrice-earnings ratio was higher for firms that reported with accelerated methods than those that reported with straight-line methodsWhen reports using one were converted to the other, price-earning ratios were essentially equalAccording to W. H. Beaver, (cont.)Accountants compete with other information providers (ex: newspapers, websites, management disclosures)Firms dont need to simplify their financial statements for everybody to understandInvestors without the time or knowledge to properly interpret information can look to the informed

Thinking critically...DO YOU AGREE? IS THIS ACCOUNTINGS MAIN ROLE? WHO DO YOU SEE AS COMPETITION FOR THE ACCOUNTING PROFESSION?

DOES THIS MAKE SENSE? WOULD INVESTORS HAVE INCENTIVE TO DO RESEARCH IF ADVANTAGES WERE SHORT-LIVED?The Informativeness of PriceTopic 4.4The Informativeness of Price

A Logical Inconsistency

Football Forecasting The Informativeness of Price

Liquidity/ NoiseTradersThe Informativeness of Price Voluntary Disclosuredisclosure of information beyond the minimum requirement of GAAP and other reporting standardsDo not want to reveal information that would give away competitive advantageConservative accounting polices

Capital Asset Pricing Model (CAPM)Topic 4.5ReturnsNet Rate of Return

Gross Rate of Return

Net Rate of Return + 1 = Gross Rate of Return

-I could introduce the variables (Define them)- Could talk about what the equations mean

20ReturnsEx Post Returns

Ex Ante Returns

-ex post is a formula that looks back to calculate the return actually realized -ex ante is when you are at the beginning of the period trying to find the expected return (where the expected price fully represents all available information-REFLECTING MARKET EFFICIENCY 21CAPM

Rjt Rate of return of stock j during time tRf Rate of return of risk free assetRMt Rate of return of Market during time t j Risk associated with stock j-Explain the formula -Beta reflects the risk component in this formula 22SignificanceWhat is the effect of new information?Ex. If investors believe Djt will be higher then what changes?Pj,t-1 must compensate since E(Rjt) is held constant

What is the effect of an improved information reporting system?Allows investors to better predict the future reducing their risk and reducing Lowers the firms cost of capitalIndustry wide impact

-Reflects newly acquired information-market efficiency-Market price holds average expectations of informed investors

-Industry wide impact on other firms and results in the ability to assess there demanded return 23SignificanceApplying the CAPMAllows investors to identify returns that were not expected at the beginning of the periodOn average is zero

CAPM allows researchers to easily estimate through regression analysis

-E=abnormal return

24Estimation RiskNot everyone may have the same belief about Large differences create volatilityHigh volatility results in risk premiums being demanded

Information asymmetry (insider information)If it exists then investors require risk premium

-the higher the asymmetry the additional premium investors will require 25Information AsymmetryTopic 4.6Information AsymmetryWhen one party in the market knows something about the product being traded that the other party does not

The Used Car Market

PoolingLack of information leads to lowering the price the buyer is willing to pay.Can be tackled by using independent disclosure devices (eg. Safety certificates). Allows the market to operate but not at maximum efficiency.

Fundamental ValueThe fundamental value of a share is the value it would have in an efficient market if there is no inside information. That is, all information is publicly available. Only a theoretical ideal. Not possible as it can reveal strategic information and is not cost effective.INSIDERTRADING

Social Significance & MD&ATopics 4.7 & 4.8Securities MarketSecurities provide the means for capital to be raised for investment needs It is socially desirable for markets to work well.

Socially Desirable? This means that firms prices reflect their fundamental value This is achieved if more useful information is provided to investors, resulting in better capital allocation

-If investors feel that there is not a level playing field then they will withdraw from making investments or lower the amount they are willing to pay for a security -underinvestment in firm relative to the socially efficient level- Markets run THIN

33Other Implications Firms are sometimes constrained on taking advantage of growth opportunities due to its ability to obtain financing. It is easier to obtain financing the higher the quality of financial reporting in their respective country -Whats in it for the firms -Invest in the most productive oppurutnities34Attaining Securities Markets that Work WellIssue: Security prices do not fully reflect fundamental value in the presence of inside informationRemedies:RegulationIncentivesRegulations: Create and Enforce regulations in place. Effective regulation reduces estimation risk Incentive- Good long term relationships with stakeholders due to honest and fair reporting of information --Both help bring firm prices closest to their fundamental value. 35MD&AProvides a narrative explanation of company operations (financial condition, performance and future prospects. -From the eyes of management -Is a discloure technique which gives management a way to communicate inside information such as future business strategies and prospects. 36HistoryBased on the requirements of National Instrument 51-102 of the OSC in 2004Was later adopted across Canada and similar requirements exist in other jurisdiction such as the United States. QuestionDiscuss the advantages and possible disadvantages of additional disclosure requirements such as MD&A. Objectives Help current/prospective investors understand the financial statements Discuss any information not fully reflected in the financial statements Any trends/risks Provide information about the variability of earnings and cash flow Is written in plain language investors are able to understand

39Disclosure Requirements Discuss firm performance in relation to assets, liabilities and revenue Indicate what accounting principles are used in the financials or if there were any changes Future outlook Relevance/ Reliability tradeoff

Future outlook- talk about risk or any uncertainties going forward. Any factors management identifies that will potentially affect performance. Also, if any forward looking information previously provided needs to be changed due to subsequent events. -This forward looking orientation tightens the connection between current and future performance (indicative)-MD&A tilts towards relevance in the tradeoff there is less of a need to wait for objective information -But do not ignore reliability entirely the board of directors approve them to reduce bias and manipulation they also must revise any previous information that is no longer the case (another way reliability is increased) 40MD&A Is a requirement that emphasizes full disclosure Reduces estimation risk due to its forward looking nature Attempts to make the markets work better by disclosing inside informationQUESTION- What are the implications of future disclosures on MD&As? ANSWER- Investor confidence is increased which reduces k, potnetial for lawsuit 41ConclusionThanks for listening!Questions?