© 2006 Pearson Education Canada Inc.

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Chapter 4

Efficient Securities Markets

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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

© 2006 Pearson Education Canada Inc.

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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

© 2006 Pearson Education Canada Inc.

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Share Price on an Efficient Market

• CAPM E(Rjt) = Rf(1 - βj) + βjE(RMt)

•Only firm-specific component is ßj

– How does accounting information affect share price? See Eq’n (4.2) in text: 1

)()(

1,

tj

jtjtjt

P

DPERE

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How Does Accounting Information Affect Share Price, Cont’d

• In Eq’n (4.2), Accounting Information Affects E( Pjt + Djt)

• E(Rjt) Does Not Change, Since Only Firm Specific Component is Beta

• Thus Pj,t-1 (i.e., current share price) Must Change in Eq’n 4.2

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4-6

Information Asymmetry

• The Adverse Selection Problem– Inside information

• Insider trading

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Social Implications of Adverse Selection

• Security Prices Do Not Reflect Fundamental Value– Misallocation of scarce capital

• All Share Prices Suffer (cost of capital)– Investors cannot distinguish good

from bad– thin markets, as investors withdraw

© 2006 Pearson Education Canada Inc.

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Social Implications of Adverse Selection,

Cont’d.• Analogy With Used Car Market

– Akerloff (1970), lemons

• In Extreme Cases, Market Collapses, or Does Not Develop in the First Place

© 2006 Pearson Education Canada Inc.

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Role of Financial Reporting

• Control Adverse Selection by Means of Full Disclosure

All Information

Inside Information

© 2006 Pearson Education Canada Inc.

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A Logical Inconsistency• Fully Informative Share Prices

– Market prices collapse– No role for accounting information

• Partly Informative Share Prices – Concept of noise traders– Expected value of noise = 0– Market efficient in expected value sense– Role for accounting information

© 2006 Pearson Education Canada Inc.

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An Example of Full Disclosure

• Management Discussion and Analysis– Forward-looking orientation– Concept of information system is

implicit– More relevant than historical cost-based

financial statements. Less reliable?– Reasonably consistent with decision

theory