EFFICIENT SECURITIES MARKETSBU427 – March 14th, 2011Andrew Baer, Peter Hanna, Kyle Lambert and Josh Ritter

OUTLINE 4.1 Overview 4.2 Efficient Securities Markets 4.3 Implications of Efficient Securities

Markets 4.4 Informativeness of Price 4.5 Capital Asset Pricing Model 4.6 Information Asymmetry 4.7 Social Significance 4.8 Example of Full Disclosure 4.9 Conclusions

4.2 – EFFICIENT SECURITIES MARKETS

Meaning of Efficiency

Implications for

Financial Reporting

Capital Asset

Pricing Model

Information

Asymmetry, Insider Trading, Adverse Selection

Full Disclosure

EFFICIENT SECURITIES MARKETSWhat is an efficient market?

“An efficient securities market is one where prices of securities traded on that market at all times fully reflect all information that is

publicly known about those securities”

EFFICIENT SECURITIES MARKETSThree things to Consider:1. Public Information

Does not include inside information

2. Relativity Efficiency is relative to company’s public

information

3. Fair Game Theory Investors cannot expect to earn excess returns

REACTION TO AVAILABLE INFORMATION

CLASS EXAMPLE – NHL RESULTS

REACTION TO AVAILABLE INFORMATION Prices will react quickly to new or revised

information Different investors will react to the same

information differently The average market will create a market price

that is superior quality to that of the individual investors

Assumption: Investors are evaluating the new information independently

4.3 - IMPLICATIONS FOR FINANCIAL REPORTING

Meaning of Efficiency

Implications for

Financial Reporting

Capital Asset

Pricing Model

Information

Asymmetry, Insider Trading, Adverse Selection

Full Disclosure

IMPLICATIONS OF EFFICIENT SECURITIES FOR FINANCIAL REPORTING1. Accounting Policies

• No effect on security prices assuming no differential effect on cash flow

2. Full Disclosure• Firms should disclose the most information

while maintaining a cost-effective approach• Additional information will not be wasted

IMPLICATIONS OF EFFICIENT SECURITIES FOR FINANCIAL REPORTING3. Naïve/Uninformed Investor

• Price Protected - efficient security prices fully reflect all that is publicly known

• Multiple media sources available to receive information without fully understanding it

4.4 - INFORMATIVENESS OF PRICE

A logical inconsistency What is “fully reflects”? Where’s the info?

Price already fully informative by definition Information acquisition can be expensive No motivation for investors to seek outside

information Must recognize other sources of security

exchanges (retire early, pay gambling debts, etc.)

Noise traders: occurs randomly and not based on the rational evaluation of available information

Imagine 2 price increase scenarios; 1. Information available more favourable to other

investors 2. Increase in price due to noise traders

PARTIALLY INFORMATIVE SECURITIES Essentially, placing of weighted possibilities

Investors now have incentive to obtain info Information reveals:

Undervalued firm: Buy! High valued firm due to noise trading: Sell

Short! Ultimately, returns price to efficient value

Security prices are partially informative for noise trading and rational expectations

EXTENT OF INFORMATION Extent of information gathered depends on:

How informative the price is Quality of financial statement information Costs of analysis

Example: big firms vs small firms Element of voluntary disclosure Rational investor must look at what manager

does for accounting policy choice and disclosure Example: firms with secret research program

PWC - UPDATE ON REPORTING STANDARDS FOR THE ADOPTION OF PE-GAAP

Top anticipated transition issue: selection of accounting policy choicesMany choices to make, ones that will have financial reporting impacts.Enterprises must beware of impacts of choices on:

Debt covenants Regulatory requirements The needs of users of the financial statements Any impact on tax calculations

Some decisions over FV are time sensitive

EFFICIENCY SUMMARY Take the term “fully reflects” with grain of

salt Not fully informative at all points in time Consider tensions between:

Level of informativeness allowed by noise traders Analysis of information in F/S to identify

misprices securities for investors Supplementary disclosures Choice of accounting policies Nature and extent of voluntary disclosure

Improved understanding of process of price information allows accountants to prepare more relevant, reliable, and useful financial statements

4.5 - CAPITAL ASSET PRICING MODEL

Meaning of Efficiency

Implications for

Financial Reporting

Capital Asset

Pricing Model

Information

Asymmetry, Insider Trading, Adverse Selection

Full Disclosure

CAPITAL ASSET PRICING MODEL (CAPM) Definition: Formalize the relationship

between efficient market price or a security, its risk, and the expected rate of return on a security

3 Equations and examples to be shown: Ex-post ROR (return actually realized during

period) Ex-ante ROR (at the beginning of time) Expected return (calculate unknown share price)

REDUCING RISK Greater financial reporting informativeness can

reduce Bj reducing cost of capital

GE Text example

Consequently, the possibility of reducing investor risk by more informative

reporting is of interest to us accountants!

3 MAIN USES1. Share prices depend on investor`s

expectations of future share price and dividends

2. Ex-post view of returns allows for separation of expected and unexpected return components

3. Market model provides a convenient way for researchers and analysts to estimate a stock’s beta.

4.6 - INFORMATION ASYMMETRY, INSIDER TRADING AND ADVERSE SELECTION

Meaning of Efficiency

Implications for

Financial Reporting

Capital Asset

Pricing Model

Information

Asymmetry, Insider Trading, Adverse Selection

Full Disclosure

INFORMATION ASYMMETRY Definition:

When one participant in the market (seller) knows something about the asset being traded that another type of participant (buyer) does not

Types of Information Asymmetry Adverse Selection – one or more parties to a

business transaction have an information advantage over other parties

Moral Hazard – one or more parties to a business transaction can observe their actions in fulfillment of the transaction but other parties cannot

Used Car Financial Market

Owner of car knows its true condition and value better than buyers

Managers know more about a firm’s true value than investors

Owner may utilize adverse selection by selling a “lemon” and making a profit

Managers utilize adverse selection by biasing, delaying, or withholding information to make a profit

Buyers can’t tell the difference between lemons and good cars and reduce the price they are willing to pay for all used cars

Investors add the potential for insider trading into their estimation risk and lower the amounts they will pay for all shares

Good cars now will not receive their proper worth and owners of good cars are less likely to bring them to market

Honest firms won’t seek as much equity financing or undergo as many capital projects as their stock is undervalued

Overall market doesn’t work as well as it should. Buyers can’t always get a car of the exact type/condition that they want.

Overall market doesn’t work as well as it should. Investors can’t buy securities with the exact risk/return they want

Market reduces asymmetry through guarantees, safety certificates, test drives, and dealers who want to establish good reputations

Market reduces asymmetry through improving financial reporting informativeness, timely reporting, and firms who want to establish good reputations

INSIDER TRADING Raj Rajaratnam, the hedge fund founder of

Galleon could face up to a 20 year prison sentence

Since October 2009 the U.S. Government has commenced the biggest probe of insider trading into the 1.9 trillion hedge fund industry

26 individuals have been charged, 19 have pleaded guilty

Rajat Gupta, former Goldman board member is also being accused of tipping off Rajaratnam

http://www.bloomberg.com/video/67410902/

Publicly Available Information

Efficient Market Price

Fundamental Value

Role of Financial Reporting

Inside Information

4.7 – SOCIAL SIGNIFICANCE OF SECURITIES MARKETS THAT “WORK WELL” Social welfare improved if capital goes to the

most productive alternatives If the market is not working well it may lose

depth Depth - The number of shares that investors can

buy or sell without affecting the market price Low of depth decreases the amount of shares

investors can buy or sell which hampers investment

Wurgler investigated markets that work well Countries with more firm specific information

incorporated into their share prices have greater capital allocation efficiency

IMPROVING MARKETS Regulation

1. Enforce regulations to control insider trading2. Promote prompt disclosure3. Penalize violations

Incentives1. Higher sales prices2. Lower cost of capital3. Reduces investor’s concerns of insider trading

4.8 – AN EXAMPLE OF FULL DISCLOSURE

Meaning of Efficiency

Implications for

Financial Reporting

Capital Asset

Pricing Model

Information

Asymmetry, Insider Trading, Adverse Selection

Full Disclosure

AN EXAMPLE OF FULL DISCLOSURE Why Full Disclosure

Best interest of companies - Trust Standards to follow

Most Frequently Used Management Discussion and Analysis (MD&A) Found in Annual Report

AN EXAMPLE OF FULL DISCLOSURE Management Discussion and Analysis

(MD&A) Requires companies to provide a narrative of

Company performance Financial condition Future prospects

Intentions Assist investors to interpret financial

statements Practical example of how information

accessible to the public can be increased

AN EXAMPLE OF FULL DISCLOSURE Key Points of MD&A

Required Amount of information is flexible Ranges between restating financial statements

and releasing inside information Regulations can be found in National Instrument

51-102 of the Ontario Securities Commission (OSC)

Applied across Canada by the Canadian Securities Administration

Similar requirements are found in the United States through the Securities and Exchange Commission (SEC)

To be written in language investors will understand

AN EXAMPLE OF FULL DISCLOSURE Objectives of MD&A

To help current and potential investors understand financial statements

To discuss information not available in financial statements

To discuss trends and risks To help investors decide if past performance is a

good indication of future performance

AN EXAMPLE OF FULL DISCLOSURE Specific Requirements of MD&A

Discuss overall firm performance Explain factors causing variations Indicate the set of accounting principles used Discuss the firm’s ability to meet short and long

term liquidity needs Discuss important commitments Discuss any changes in accounting policy Explain performance affected by trends and risks Describe financial instruments used to manage

risks

AN EXAMPLE OF FULL DISCLOSURE Notable Aspects of MD&A

Forward looking Specifies the relationship between current

financial statements and future performance Favours relevance over reliability (emphasis on

timing)

AN EXAMPLE OF FULL DISCLOSURE Relevance of MD&A Encourages full disclosure Forward-looking information Discusses industry risks Helps investors reduce estimation risk

AN EXAMPLE OF FULL DISCLOSURE Refer to pg 122 for Canadian Tire award

winning example of MD&A

AN EXAMPLE OF FULL DISCLOSURE Babcock & Wilcox Canada

AN EXAMPLE OF FULL DISCLOSURE Risks:

Potential for lawsuits Loss of investors trust when plans not met

Benefits: Reduce estimation risk Lowers cost of capital Potential to boost investor confidence

4.9 – SUMMARY/CONCLUSION Efficiency is relative to a stock’s publicly

known information Financial reporting plays a role in improving

the amount, timing and accuracy of the stock’s information

Going beyond minimal reporting shows confidence

Noise, liquidity traders and insider trade ensure that investors take the time and effort to collect information