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 Chapter 4
Overview

• Efficient markets
• Measures of expected net income
• Beaver’s Analyses
• Informativeness of Price
• Capital Asset Pricing Model
• Adverse Selection

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 Market Efficiency
Security prices
– At all times…
– Fully reflect...
– All publicly available information… (semi-strong)
• Is private information reflected in prices (in efficient markets)?
– Only in strong form efficiency

– Sometimes market efficiency is challenged (Ch. 5).

• All public information not incorporated in prices instantly.
• It takes time for public information to be incorporated in prices.
– In that case, investors can profit from public information.
– Explain How?

• How would prices react to new information under efficiency?

Under inefficiency? Show graphically.
– Under efficiency, it would spike up (almost vertically), and then sort of
level off! It has to go up right away because as soon as the info becomes
available, everyone wants to buy more, and the demand rises, and so the
price shoots up and then sort of levels off.
– If you have inefficiency, then it would take several days (maybe 10) for the 4-3
price
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Inc.rise; so it would rise over time
 Price Formation
• Public information leads to belief revisions about future outcomes
• Information.
• News (evidence) that can affect decisions.

• How to measure News (e.g. Good or Bad News) ?

– Net Income (say, third quarter 2012) = $2.00 per share.
– Is it Good News or Bad News ?
– It depends on the expectations/forecasts! You need a benchmark of expectations! That could
be the analyst’s forecast of 2012 Q2 NI/share.
– It could also be NI actual of 2012 Q1; but a better measure would be 2011 Q2 (because of
seasonality)
– Another benchmark could be Accretion of Discount, which is SHEQ (beg) or NA (beg) x E(r/r)
[expected rate of return]
– You might also use comparables
– Explain with respect to RBC (see attachments 1,2 and 3)
– The first top section shows analyst estimates
– The second part shows how estimates were revised over time; so it shows belief revision
since analysts adjusted their estimates; what was the info that cause them to change their
belief; that’s something to think about!
• Will it change stock prices ? Why ?
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 Accounting Policy Change and Price
• W. Beaver,
• Effects of Changes in accounting policies on:
• Financial Statements?
• NI is greater due to change in accounting policies. (e.g. change
depreciation method)
• Will Stock Prices change (Increase)?
• In an efficient market it still won’t change under the 3 conditions below
• In most cases, there aren’t changes…?

Beaver’s conditions under which no change in prices as a result of

changes in accounting policy ?
1) No direct effect on cash flow (note that there could be indirect effect)
2) Policies are disclosed (and people understand them)
3) Enough info is provided/available for the reader/user to convert from one
method to other

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 Is Price fully Informative?

• Assume that prices are fully informative.

• What happens to incentives to seek out new
information?
– In reality, prices are partially informative; not fully!
– There’s no incentive because that information will
already be reflected in the price, and therefore, there’s
no way to benefit or profit from having that info

• The logical inconsistency is resolved by the

existence of Liquidity traders in the market.
• Explain how
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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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 Rate of Return on Security

• Realized Rate of Return on a Security, Rjt

• =(Pt + Dt - Pt-1)/Pt-1

• =[(Pt + Dt )/ Pt-1 ]– 1

• How is this different from expected returns?

– This is different from expected since it doesn’t depend beta
• CAPM applies to realized or to expected returns?
– CAPM applies to expected returns; and it depends on risk (beta)
– The abnormal return is actual less expected

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 Capital Asset Pricing Model (CAPM)

CAPM, reflects Risk and Expected Returns

E(Rjt) = Rf(1 - βj) + βjE(RMt)
• ßj is Beta risk.
• What is beta risk?
• The only firm specific component. Why ?

• What are Abnormal Returns?

– Actual minus expected returns

• See attachments 2 and 3 relating to RBC

• Explain how to isolate capital market effects of
RBC’s Q3 earnings news released on Aug 26 ? 4-9
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 A Capital Asset Pricing Model (continued)
• Critique of the CAPM
– CAPM assumes rational expectations
• Investors assumed to know beta
• In practice, investors do not know beta, so must estimate it,
creating estimation risk.
• What is the effect of this estimation risk on expected returns?
Are they understated or overstated ?
– Understated if based on CAPM (since investors would expect a higher
return with the additional risk)
– CAPM assumes common knowledge
• Everyone knows that everyone knows beta, etc.
• This rules out sophisticated investors’ ability to take advantage
of ordinary investors who have inferior knowledge of beta
– CAPM assumes no transactions costs and liquid markets
– CAPM assumes rational investors
– Despite these limitations, CAPM is a good place to start to 4 - 10
appreciate the role of information in capital markets
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 Market Model

Rit = αi + βi RMt + εit

Where Rit is returns realized over period ‘t’.

AND, RMt is market returns realized over period t

What is the difference between the market model

and CAPM?

Describe how market model can be used to estimate

βi
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 Adverse Selection

• What is Adverse Selection?

• When one party has more info than the other
party in a transaction

• What is inside information ?

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 Example of Adverse Selection
• Used Car Market. Akerloff (1970) on lemons.
– Owners of used cars have more information than outsiders

• What is the effect of adverse selection on the average quality of

used cars in the market? High or low ? Why? What is pooling ?
– Pooling is that you can’t distinguish between good and bad
– Estimation risk also plays a role here since one party doesn’t know the
quality of the car?
– The market is there only for lemons
– The average quality would drop!
– Only low quality would be in the market

• What is the effect of adverse selection on the average price of

used cars the market?
– Price would be low

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 Effect of Adverse Selection
Owners of good cars have motivation to reduce adverse
selection.
• Why ?
• So that they can get a good price for their car!

• How can owners of good used cars convey quality credibly?

• Repair records; something that’s hard for the lemon owner to
mimic; and it’s too expensive for the lemon owner to
provide; if the lemon guy tries that, there’s a penalty for false
info, and false signaling. E.g. certification; test drive, etc.

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 Alleviation of Adverse Selection
• Would firm shares be bought under
conditions of adverse selection?For
example, when potential investors feel that
firm insiders have superior information.

• Adopting policy of full disclosure.

• Requiring Timely reporting of material events.
• Penalties imposed for insider trading.

• Provide mechanisms for firms to communicate

information credibly.

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 No Adverse Selection:
Fundamental Values

The fundamental value of a share

What is it ?

Does share price equal fundamental value of a share?

Inside information
Does share price incorporate inside information in an efficient
market ?

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 Information Asymmetry

• Effect of estimation risk on share prices

– Efficient market price includes a “discount” for
expected estimation risk (i.e., for expected losses at the
hands of insider trading)
– CAPM may understate cost of capital, since ignores
estimation risk
– To some extent, estimation risk may be diversified away,
but, since outside investors more likely to lose than gain
from insider trading, some discount will remain

» 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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 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 effects of
low adverse selection

• Social role of financial reporting

– To help markets work well
• Maximize amount of publicly available information

• Subject to a cost-benefit constraint.

– What are the costs to firms of disclosing more
information?

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