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Financial Accounting Theory

Sixth Edition
William R. Scott

Chapter 4
Efficient Securities Markets

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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

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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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4.4 The Informativeness of Price

• Fully informative share prices


– If share prices are fully informative, noone 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, noone would bother to gather information, etc.,
etc.
– Hence the logical inconsistency

>> Continued

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The Informativeness of Price (continued)

• A way out of the logical inconsistency


– Noise trading
• Expected value of noise = 0
• Share prices still efficient, but in an expected value sense
– Share prices are partially informative in presence of
noise trading
• Share price may deviate from its efficient value due to
noise trading
• Restores incentive of investors to gather information

>> Continued

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4.5 A Capital Asset Pricing Model

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

>> Continued

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A Capital Asset Pricing Model (continued)

• 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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A Capital Asset Pricing Model (continued)

• CAPM assumes rational expectations


– Investors know beta
• In practice, investors do not know beta, so must
estimate it
– This is an example of estimation risk

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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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Information Asymmetry (continued)

• Investor reaction to inside information


– Inside information 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

» Continued

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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 understates cost of capital, since ignores
estimation risk

» Continued

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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?
• Definition of 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)

» Continued

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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

• Social role of financial reporting is enhanced if


securities markets are efficient
– Then, market fully uses financial accounting information

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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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