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Chapter 4 Efficient Securities Markets

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Chapter 4 Efficient Securities Markets Powered By Docstoc
					 Efficient Securities
       Markets
                 Scott
               Chapter 4


EMH & CAPM - Theories developed in the 1960s   1
     Efficient Market Hypothesis
   Assumptions
    • Active market with large numbers of rational,
      profit-maximizing investors
    • All market participants have same information
    • Prices respond only to available information
    • Therefore, equilibrium prices reflect all
      available information
   No one will have the ability to out-profit
    anyone else
    • Investing is a FAIR GAME
                                                      2
         EMH – Three Forms
   The "Weak" form
    • Technical analysis useless
   The "Semistrong" form
    • Fundamental analysis useless
   The "Strong" form
    • Inside information useless



                                     3
     Securities Market Efficiency
   IMPLICATIONS:
    • Random walk
        Prices cannot be predicted

        No investment pattern can be discerned

        Best estimate of future price is current price

    • Given transaction costs, EMH predicts index
      fund would be more profitable than a
      managed portfolio
    • Role of accounting information???
                                                      4
Accounting Implications of EMH
   Accounting policies selected by firms don’t
    matter when
    • There is full disclosure
    • No cash flow effects
   More information is better for markets
    • Cost/benefit considerations?
   “Naïve” investors price-protected
   Many sources of information
    • Accountants in competition with other
      providers

                                                  5
           CAPM
E(Rjt) = Rf(1 - βj) + βjE(RMt)



        expected security return =
              riskless return +
        beta * (expected market risk
                  premium)


                                       6
The Capital Asset Pricing Model
   ASSUMPTIONS
    •   All assets in the world are traded
    •   All assets are infinitely divisible
    •   All investors in the world collectively hold all assets
    •   For every borrower, there is a lender
    •   There is a riskless security in the world
    •   All investors borrow and lend at the riskless rate
    •   Everyone agrees on the inputs to the Mean-STD picture
    •   Preferences are well-described by simple utility
        functions
    •   Security distributions are normal, or at least well
        described by two parameters
    •   All investors have identical investment horizons (two
        time periods)
    •    All investors have identical opinions about expected
        returns, volatilities and correlations of available
        investments
    •   The are no transaction costs and no taxes
                                                                  7
CAPM – every investment carries
two distinct risks
              The risk of being in the market
               • Systematic risk - beta
               • Cannot be diversified away


              Unsystematic risk - specific to a
               company's fortunes
               • Can be mitigated through
                 appropriate diversification
               • Therefore, a portfolio's expected
                 return hinges solely on its beta


              Bill Sharpe-
       co-winner of 1990 Novel                       8
          Prize in Economics
Interview with Bill Sharpe
      Did the CAPM evolve? Of course.
       … But the fundamental idea
       remains that there's no reason
       to expect reward just for
       bearing risk. Otherwise, you'd
       make a lot of money in Las
       Vegas. If there's reward for risk,
       it's got to be special. There's got
       to be some economics behind it
       or else the world is a very crazy
       place. I don't think differently
       about those basic ideas at all.

                                             9
    Limitation of Portfolio Theory
   Diversification can eliminate
    nonsystematic risk
   Risk associated with economy-wide
    events remain
    • Changes in interest rates
    • Inflation
    • Recession


                                        10
    Role of Accounting Information
   For investors:
     • Usefulness =
       information helpful in predicting the
       future cash flows that accrue to the
       investor as a result of holding the
       investment
   Two sources of cash flows:
     • Dividends            Distribution of Earnings

     • Sale of investment
                                                       12
         Equation 4.1, p. 103
Actual return (ex post concept)
                Pjt + Djt
Rjt =                         -1
                  Pj,t-1

Expected return (ex ante concept)
               E(Pjt + Djt)            4.1
 E(Rjt) =                         -1
                   Pj,t-1
                                         13
Link Between FS & Stock Price
                       Predict Future
                          Earning
 Accounting
 Information            Payout Ratio
Accrual-based
   Current
                          Expected
   Earnings
                           Future
                          Dividends

                                 Permanent vs.
                                   Transitory
                Future Stock        Earnings
                    Price                  14
Hierarchy of Income Numbers
   Core earnings: net income before unusual
    and non-recurring items
   Unusual and non-recurring items
   Operating income: Income from
    continuing operations
   Discontinued operations
   Extraordinary items
   Cumulative effect of accounting change
   Net income
                                               15
                CAPM return
   CAPM
     E(Rjt) = Rf(1 - βj) + βjE(RMt)            4.2
         Only firm-specific component is ßj

    • How does accounting information
      affect share price?


                  E(Pjt + Djt)                 4.1
E(Rjt) =                           -1
                      Pj,t-1                         16
     A Logical Inconsistency (1)
   Market efficiency means information
    is both available and used
    • Fully Informative Share Prices
         Market price = intrinsic value
         No role for accounting information


   If investors believe EMH …


                                               17
     A Logical Inconsistency (2)
   Partly Informative Share Prices
    • Two types of investors
         Rational speculators or arbitrageurs
         Noise traders who trade on the basis of
          imperfect information
    • Expected value of noise = 0
    • Market efficient in expected value sense
    • Role for accounting information

                                                    18
    Market Response to Earnings
   Ballard Power Systems Inc.
    • 4th Quarter loss doubles compared with
      same quarter of previous year
    • R & D spending up
    • revenue doubles
   Is rise in share price to $189
    “efficient?”


                                           19
          Information Asymmetry
   The Adverse Selection Problem
    • Inside information
         Insider trading


   The Moral Hazard Problem
    • Manager shirking




                                    20
         Social Implications of
          Adverse Selection
   Security prices do not reflect
    underlying value
    • Misallocation of scarce capital
   All share prices suffer (cost of
    capital)
    • Investors cannot distinguish good from
      bad
    • Thin markets, as investors withdraw
    • In extreme cases, markets collapse

                                               21
     Role of Financial Reporting
   Control Adverse Selection by Means
    of Full Disclosure


                          All Information



                           Inside Information


                                                22
     Examples of Full Disclosure
   Management
    Discussion and
    Analysis

   Future Oriented
    Financial
    Information



                                   23
         Discuss Question 2
   Two firms – same size and risk
   Report same net income
   Firm A uses LIFO and declining
    balance depreciation
   Firm B uses FIFO and SL depreciation
   Which stock should sell at a higher
    price/earnings ratio?

                                       24
        Problem 5 – GE             4 th   Qtr
              Earnings
   Actual EPS = $1.57        Expected EPS =
    for quarter                $1.61 for quarter
   Actual annual EPS         Expected annual
    = $5.51                    EPS = $5.50 to
                               $5.60
Stock price fell $1.59 on day of earnings
announcement
1. Give 3 reasons to explain why this could happen
2. Use CAPM to explain how new information
caused the price drop                                25

				
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