CHAPTER SIX: ANALYSIS OF INFORMATION STRUCTURE ON THE FIANANCIAL MARKET

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The Importance of Market Efficiency Understanding the If and How the EMH Principal can Affect Shareholder Wealth • Understanding how securities are valued is important because these valuation principles provide guidelines to managers how they should manage businesses on behalf of the shareholders. • It is the legal requirement and managerial responsibility for managers to act in the owners’ best interest. • The discount rate that represents shareholder’s required rate of return is established as a result of benchmark rates in the capital markets such as the Risk-Free Rate (RF) and the market risk premium....

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CHAPTER SIX: ANALYSIS OF INFORMATION STRUCTURE ON THE FIANANCIAL MARKET 06/08/2011 1
The Importance of Market Efficiency Understanding the If and How the EMH Principal can Affect Shareholder Wealth • Understanding how securities are valued is important because these valuation principles provide guidelines to managers how they should manage businesses on behalf of the shareholders. • It is the legal requirement and managerial responsibility for managers to act in the owners’ best interest. • The discount rate that represents shareholder’s required rate of return is established as a result of benchmark rates in the capital markets such as the Risk-Free Rate (RF) and the market risk premium. • A question remains…DO MARKET PRICES REFLECT THE ACTIONS OF MANAGERS? – If they do, then managers must learn what actions they should take in order to fulfill their legal and managerial responsibilities to shareholders. 06/08/2011 2
The Importance of Market Efficiency Three Elements to Market Efficiency • Operational Efficiency – Transactions costs are low, thereby enhancing trading of securities • Allocational Efficiency – There are enough securities to efficiently allocate risk • Informational Efficiency – Market prices fairly and quickly reflect all available information. 06/08/2011 3
The Importance of Market Efficiency Informational Efficiency • Informational Efficiency is the focus of this chapter. • The closer the link between actions of managers and the value of the firm, the more informationally-efficient the capital market. 06/08/2011 4
The Importance of Market Efficiency Securities Laws Affecting Public-Issuers of Securities Securities laws in Canada reflect the belief that there is (or should be) a strong connection between information and stock prices and these laws reflect a number of common principles related to parties to transactions and access to information: – Continuous disclosure of all material information about the firm. • Publicly-traded firms fulfill this responsibility through publication of annual audited financial statements, unaudited quarterly financial statements, and through timely press releases and announcements of anything that could ‘materially’ affect the share price of the firm. – Fair and equal treatment of all market participants through disclosure requirements that ensure all participants have simultaneous access to the same information about publicly-traded firms. • The use of cease-trading orders when new information is being released to the market is an example of how regulators ensure that information is widely disseminated to all market participants before trading is allowed to occur. In this way, all market participants are trading on the basis of the same and complete information ensuring that some participants do not have an informational advantage over others. 06/08/2011 5
Asymmetric Information • Asymmetric information is when one party to a transaction has access to more a complete and accurate set of facts than the other party. – When this condition exists, it is possible for the party with better information to use that at their own personal gain, and at the expense of the other. 06/08/2011 10 - 6
Asymmetric Information An Example – The Used Car! An example of Asymmetric information from everyday life might be the situation between a buyer and seller of a used car in a private transaction. – The seller has intimate knowledge of recent car history including past owners, collisions, repairs, and problems. – The buyer (presuming no expertise as a mechanic) has only their limited skills of observation and investigation to inform their purchase decision. In the foregoing example, it is possible, in the absence of rules and regulations, for the seller to take advantage of the buyer because of information asymmetry. This means, the buyer is likely to pay more for the car than they should! The seller reaps the rewards of superior information. In some provinces, before such a transaction can occur, a sellers information package must be obtained from the Ministry of Transportation. This package will include an estimate of wholesale and retail price of the used car, and a list of past owners. This is an example of government regulation to try to reduce the information advantage sellers have over buyers. 06/08/2011 7
Disclosure and Market Efficiency The Asymmetric Information Challenge • If informational advantages were widely permitted, and if there were a persistent advantage of some market participants over others, the credibility of the markets would be shaken. • Under such circumstances, many people would choose not to invest in securities, choosing, instead to put their money into managed deposits, or worse, choosing to hide their money under a pillow. • This would significantly reduce the number of market participants, and the amounts of money invested in the markets. • The result would be: – Less market efficiency – and even fewer willing participants! – Lower security prices in general – Infrequent trading of securities – Increasing ability of one market participant to affect the security price through their actions. • Ultimately, the capital market would not be able to channel sufficient surplus funds to underwrite economic activity such as plant expansions, research and development, etc. In the end, companies would lack capital, and increasingly become inefficient and ineffective in their markets. Jobs would be lost and the standard of living of all would decline. 06/08/2011 8
Defining Market Efficiency What is an Efficient Market? An Efficient Market … • Is a market that reacts quickly and relatively accurately to new public information, which results in prices that are correct, on average. 06/08/2011 9
Market Efficiency Requisite Conditions For markets to operate efficiently some conditions must exist: 1. A large number of rational, profit-maximizing investors exist, who actively participate in the market by analyzing, valuing, and trading securities. The markets must be competitive, meaning no one investor can significantly affect the price of the security through their own buying or selling. 2. Information is costless and widely available to market participants at the same time. 3. Information arrives randomly and therefore announcements over time are not serially connected. 4. Investors react quickly and fully (and reasonably accurately) to the new information, which is reflected in stock prices. 06/08/2011 10
Efficient Market Hypothesis (EMH) Defined The Efficient Market Hypothesis is • The theory that markets are efficient and therefore, in its strictest sense, implies that prices accurately reflect all available information at any given time. 06/08/2011 11
Efficient Market Hypothesis (EMH) Weak Form EMH • The theory that security prices reflect all market data, referring to all past price and volume trading information. • Implication: – If Weak Form efficient, historical trading data will already be reflected (discounted) in current prices and should be of no value in predicting future price changes. 06/08/2011 12
Efficient Market Hypothesis (EMH) Semi-strong Form EMH • The theory that all publicly known and available information is reflected in security prices. • Assumes the weak-form set of information as well as all public information pertinent to the security such as: – Earnings – Dividends – Corporate investments, – Management changes • Implication: – If semi-strong efficient, it is futile to analyze public information such as earnings projections and financial statements in an attempt to identify underpriced or overpriced securities. 06/08/2011 13
Efficient Market Hypothesis (EMH) Strong Form EMH • The theory that stock prices fully reflect all information, which includes both public and private information. • Implications: – Stock prices are fairly priced. – It is not possible to use public information to identify over-priced or under-priced stocks – It is not possible to use insider information to identify over-priced or under-priced stocks 06/08/2011 14
Weak Form EMH • States that security prices fully reflect all market data – All past price and trading volume data • If markets are weak form efficient historical trading data will already be reflected in current prices and should be of no value in predicting future price changes. 06/08/2011 15
Semi-Strong Form of EMH • States that all publicly known and available information is reflected in security prices. • This includes information about: – Earnings – Dividends – Corporate investments – Management changes, etc. • A market that quickly incorporates newly released information (to the public) is semi- strong efficient. 06/08/2011 16
Implications of Market Efficiency • Empirical Evidence suggests: – Markets reach quickly and relatively accurately to new public information – Market prices are correct on average • Markets may not be perfectly efficient, but they are relatively efficient. 06/08/2011 17
Implications of Market Efficiency Implications for Investors 1. Technical analysis is not likely to be rewarded. 2. Fundamental analysis is also unlikely to be successful at generating abnormal profits after transactions costs, research costs and taxes. 3. Active trading strategies are unlikely to outperform “passive” buy-and-hold strategies…favouring index mutual funds or exchange-traded funds (ETFs) 4. Investors should focus on the basics of good investing by defining investment goals in terms of expected return and acceptable risk levels. 06/08/2011 18
Implications of Market Efficiency Implications for Corporate Officers 1. Timing of security issues or share repurchases in unimportant because prices are correct on average. 2. Management should monitor the price of the firm’s securities to see whether price changes reflect new information or short-run momentum and/or overreaction. 06/08/2011 19
Executive Compensation Some further thoughts • In an effort to align the interests of agents (managers) with those of the principal (shareholders) compensation is often ‘tied’ to stock performance. • If markets are not ‘efficient’ then that basic premise is violated. • Stock prices can change because of company-specific reasons as well as systemic reasons – Why should a manager be rewarded for ‘riding the wave’ of systemic upward movements in all stock prices? 06/08/2011 20