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Sheikh Abbas Ali Datoo Wilson Man Chirag Shamdasani Hermanraj Singh Rachel Tam Slide 2 Slide 3 The Meaning of Efficiency What happen when a large amount of rational investors interacting in a securities market? Characteristics of market prices of securities traded in market How are prices affected by new information? Slide 4 The Meaning of Efficiency 2 conditions Ideal conditions Information is free Non-ideal conditions Information is not free Slide 5 The Meaning of Efficiency Investors who spend considerable time and money to use information sources to guide their investment decisions are known as informed Move quickly given the new information Market becomes efficient when a sufficient number of investors behave this way Slide 6 The Meaning of 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 that is publicly known about those securities Slide 7 The Meaning of Efficiency 4 points about efficiency: 1. Market prices are efficient with respect to publicly known information 2. Market efficiency is a relative concept 3. Investing is a fair game if the market is efficient 4. Given market efficiency, a securitys market price should fluctuate randomly over time Slide 8 How do Market Prices Fully Reflect all Available Information? Market price of a security is the result of demand and supply of the security by investors Investors are still likely to react differently given the same information The differences average out Assume individual decisions are independent Slide 9 Section 4.3 Slide 10 According to W. H. Beaver, Accounting policies adopted by firms do not affect their security prices If the benefits of disclosing information outweighs its cost, the information should be disclosed Slide 11 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? Slide 12 Empirical evidence showed... There is in fact no increase in securities prices by changing to an accounting method that increases reported earnings Price-earnings ratio was higher for firms that reported with accelerated methods than those that reported with straight-line methods When reports using one were converted to the other, price-earning ratios were essentially equal Slide 13 According 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 understand Investors without the time or knowledge to properly interpret information can look to the informed Slide 14 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? Slide 15 Topic 4.4 Slide 16 The Informativeness of Price A Logical Inconsistency Football Forecasting Slide 17 The Informativeness of Price Liquidity/ Noise Traders Liquidity/ Noise Traders Slide 18 The Informativeness of Price Voluntary Disclosure disclosure of information beyond the minimum requirement of GAAP and other reporting standards Do not want to reveal information that would give away competitive advantage Conservative accounting polices Slide 19 Topic 4.5 Slide 20 Returns Net Rate of Return Gross Rate of Return Net Rate of Return + 1 = Gross Rate of Return Slide 21 Returns Ex Post Returns Ex Ante Returns Slide 22 CAPM R jt Rate of return of stock j during time t R f Rate of return of risk free asset R Mt Rate of return of Market during time t j Risk associated with stock j Slide 23 Significance What is the effect of new information? Ex. If investors believe D jt will be higher then what changes? P j,t-1 must compensate since E(R jt ) 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 capital Industry wide impact Slide 24 Significance Applying the CAPM Allows investors to identify returns that were not expected at the beginning of the period On average is zero CAPM allows researchers to easily estimate through regression analysis Slide 25 Estimation Risk Not everyone may have the same belief about Large differences create volatility High volatility results in risk premiums being demanded Information asymmetry (insider information) If it exists then investors require risk premium Slide 26 Topic 4.6 Slide 27 Information Asymmetry When one party in the market knows something about the product being traded that the other party does not The Used Car Market Slide 28 Pooling Lack 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. Slide 29 Fundamental Value The 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. Slide 30 INSIDER TRADING Slide 31 Topics 4.7 & 4.8 Slide 32 Securities Market Securities provide the means for capital to be raised for investment needs It is socially desirable for markets to work well. Slide 33 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 Slide 34 Other 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 Slide 35 Attaining Securities Markets that Work Well Issue: Security prices do not fully reflect fundamental value in the presence of inside information Remedies: Regulation Incentives Slide 36 MD&A Provides a narrative explanation of company operations (financial condition, performance and future prospects. Slide 37 History Based on the requirements of National Instrument 51- 102 of the OSC in 2004 Was later adopted across Canada and similar requirements exist in other jurisdiction such as the United States. Slide 38 Question Discuss the advantages and possible disadvantages of additional disclosure requirements such as MD&A. Slide 39 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 Slide 40 Disclosure 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 Slide 41 MD&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 information Slide 42 Conclusion Slide 43 Thanks for listening! Questions?