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CHAPTER 4
Efficient Securities Markets
4.1 Overview
4.2 Efficient Securities Markets
4.2.1 The Meaning of Efficiency
4.2.2 How Do Market Prices Fully Reflect All Available Information?
4.2.3 Summary
4.3 Implications of Efficient Securities Markets for Financial Reporting
4.3.1 Implications
4.3.2 Summary
4.4 The Informativeness of Price
4.4.1 A Logical Inconsistency
4.4.2 Summary
4.5 A Model of Cost of Capital
4.5.1 A Capital Asset Pricing Model
4.5.2 A Critique of the Capital Asset Pricing Model
4.5.3 Summary
4.6 Information Asymmetry
4.6.1 A Closer Look at Information Asymmetry
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4.6.2 Fundamental Value
4.6.3 Summary
4.7 The Social Significance of Securities Markets That Work Well
4.8 Conclusions on Efficient Securities Markets
LEARNING OBJECTIVES AND SUGGESTED TEACHING APPROACHES
1. Securities Market Efficiency
I do not spend much time on securities market efficiency per se, since most students
have been exposed to this concept in previous course work. However, I do consider the
following aspects:
(i) The definition of semi–strong form efficiency. I point out that efficiency
here is a relative concept. That is, efficiency is with respect to a set of publicly available
information. If this is of poor quality, if there is not “enough” of it in the public domain, or
if it is simply wrong, security prices will efficiently reflect this poor information. Then, it is
natural to suggest that financial reporting has a role to play in improving the quality and
quantity of publicly available information. For example, it can play a role in converting
inside information into publicly available information.
(ii) I integrate with Chapter 3 by suggesting that a way to think about
securities market efficiency is to envisage a large number of investors making rational
investment decisions, such as Bill Cautious in Chapter 3, interacting in a securities
market. Market price is what results from their collective decisions. I also emphasize
that belief revision is a continuous process, that is, investors are constantly revising
their state probabilities as new information comes in from any source, not just when
financial statements are released. This reinforces Beaver’s 1973 argument in Section
4.3 that accounting competes with other information sources for decision usefulness to
investors.
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(iii) One of my favourite examples is Beaver’s football forecasting example
(Table 4.1). I use this example to show intuitively how market prices can have efficient
properties even though individual investors are fallible. The class will respond with
interest to a suggestion that departures from rational decision making are symmetrically
distributed (i.e., departures in the sense of not in accordance with the decision–theoretic
investment decision described in Chapter 3), so that “errors” in decision making cancel
out in the market price. If I make this suggestion, I am careful to point out that it
implicitly assumes that the distribution of departures from rational behaviour is
unbiased, that is, it is centred on the “correct” security price. This reinforces the point
made in Chapter 3 that the decision theory model is interpreted as a model of the
average investor, not each individual investor. Discussion of behavioural theories and
evidence that suggests that investors on average may be biased is postponed to
Section 6.2.
It is interesting that the cancelling of errors phenomenon appears in many different
contexts. A recent book provides numerous other examples to expand on Beaver’s
illustration that, in many different contexts, a group makes decisions that are superior to
those of the individuals in the group. Interested instructors may wish to consult The
Wisdom of Crowds (2004) by James Surowiecki—see bibliography, also Note 3 to this
chapter.
2. Efficient Securities Markets
I argue that market efficiency is a matter of degree (as opposed to the market being
either efficient or not efficient) and conclude (Section 6.7) that securities markets are
usually close enough to being fully efficient that the efficient securities market model is
the most useful model to guide accountants as to the information needs of financial
statement users and the social role of financial reporting. Consequently, an
understanding of the theory and implications of securities market efficiency is still
important for accountants.
Securities market efficiency theory, and, more generally, economic models which
assume that individuals are rational, have received severe criticism as a result of the
2007–2008 market meltdowns. This is largely because the rational theory did not predict
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the meltdowns. In this edition, I work hard to defend rational decision theory from these
criticisms. This defence begins in Section 4.5.2 (optional section) with an explanation of
the rational expectations, common knowledge, no inside information, and perfect
liquidity assumptions on which many rational economic models, including the CAPM,
draw. While the main purpose in Section 4.5.2 is to acquaint the interested reader with
these assumptions and their significance, they anticipate my argument, more fully
developed in Sections 6.5, 6.6, and 6.7, that if rational economic modelling is to recover
from the criticisms, theorists should consider dropping these assumptions. That is,
arguably, it is not lack of (on average) investor rationality that is the real culprit, but
rather the failure of many economic models to recognize (common knowledge
assumption) that the securities market contains different classes of investors with
different levels of ability and information, and a failure to consider more closely (rational
expectations assumption) how investors process information. The market meltdowns
have also increased accounting researcher’s attention to market liquidity—Section 7.7
gives a brief discussion.
A more detailed defence of investor rationality, including outlines of rational models
which drop rational expectations or common knowledge, is given in Section 6.5.
3. Implications of Securities Market Efficiency for Financial Reporting
I always assign Beaver’s 1973 article (Section 4.3) as supplementary reading, followed
by discussion in class. While quite old, the article is still relevant, and it is quite
readable. The main point I make is that managers should not care about accounting
policy choice if one takes securities market efficiency literally. With an eye to the future
direction of the text, this argument conflicts with the message of Chapter 8 on contract
theory and economic consequences, which is that managers do care. Chapter 9 works
to reconcile these seemingly inconsistent observations.
4. The Demand for Financial Accounting Information When Securities Markets
are Efficient
A literal interpretation of securities market efficiency may suggest a limited scope for
useful financial statement information. One argument is that historical cost–based
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financial statements may be superseded by more timely information sources. Another
argument is that whatever information content financial statements have will very
quickly get built into share price when markets are efficient. Thus, for most investors,
share price already reflects what they might learn from the financial statements.
To “wave the flag” for financial reporting, it is important to counter such arguments. To
do so, I begin with a very intuitive discussion of Grossman’s (1976) argument given in
Section 4.4.1, that share prices will self–destruct if they are fully informative, that is, if
they always fully reflect all publicly available information. Students usually have no
difficulty in seeing this intuitive argument, particularly if it is related back to the Beaver
football forecasting example by asking what would happen if the various forecasters
gave up on gathering information and simply agreed on a consensus forecast.
I then ask the class why share prices do not collapse as predicted by Grossman’s
argument, and steer the discussion to the concept of noise traders. I end up by
emphasizing that noise trading introduces a random component into share price. It is
important to point out that share prices are still efficient, but in an expected value
sense. That is, because noise has expectation zero, share price is on average an
unbiased reflection of publicly available information. But, at any point in time, noise
traders may cause price to depart from this fully informative value. This reconciles
securities market efficiency with a continuing motivation for private information search
to discover over– or under–valued securities. Hopefully, at least some of this private
information search will be directed to accounting information. The private information
search argument can be strengthened by pointing out that there is often not a clear
dividing line between inside and outside information, and that astute private information
search may ferret out such inside information.
5. Information Asymmetry
In Section 4.6 I come back to the problem of adverse selection introduced in Chapter 1.
I begin with an intuitive discussion of the “lemons” problem as analysed by Akerlof
(1970). Students readily see the analogy between the used cars market and the
securities market. I then ask what mechanisms there are to prevent securities market
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collapse because of the adverse selection problem of inside information. The following
are worth some discussion:
(i) Penalties, such as investigations, fines and publicity for insider trading
violations.
(ii) Incentives, such as full disclosure of lots of relevant and reliable
information. I point out that such disclosures must be credible and ask whether
(audited) financial statement information is more credible than other sources, such as
information on company websites, speeches by company officials, and media reports.
I bring out the concept of estimation risk, noting that this risk is similar to the risk faced
by the purchaser of a used car. Estimation risk is an important concept running
throughout the text. It explains why better disclosure can reduce a firm’s cost of capital
(the CAPM cannot explain this, since it ignores estimation risk– its only firm-specific
variable is beta). Estimation risk also helps to explain why reporting on firm specific risk
(e.g., MD&A) is useful. Note that reduction of estimation risk, disclosure of inside
information, and control of adverse selection are similar concepts, and that full
disclosure helps attain all of them.
Finally, I find Figure 4.2 helpful in developing the concept of fundamental value of a
security. In particular, the gap between the (semi strong) efficient market price of a
security and its fundamental value represents inside information (information
asymmetry), which full disclosure can reduce.
The Social Significance of Securities Markets that Work Well
I usually refer briefly to this section, by asking the class what makes financial reporting
valuable. This is a good occasion to point out to the students that, as accountants, they
are working for the good of society, not simply for the good of the client or employer.
The demise of Arthur Andersen & Co. (not covered in this book), who were the auditors
of Enron, WorldCom, and several other firms with overly aggressive accounting,
illustrates this point. Instructors who introduce ethics into their classes may wish to
develop this argument further.
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SUGGESTED SOLUTIONS TO QUESTIONS AND PROBLEMS
1. The differing market response could be explained by a difference in the market’s
expectations of earnings. The net income of the firm that had the strong reaction
may have been higher than expectations, whereas the net income of the other
firm may have been equal to or less than expectations.
2.
shareperincomeNet
sharepervalueMarket
ratioearningstoice =Pr
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income suggests higher expected future payoffs for firm A than firm B. Since
investors value higher future payoffs and the higher share returns these imply,
3. a. This occurs if the market perceives the new car dealer as more reputable
than the used car dealer. Then, estimation risk of buying a used car is relatively
low. For example, the new car dealer may stand behind used cars sold to a
greater extent than the used car dealer. The new car dealer may offer a superior
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to be more careful. The moral hazard problem arises because of information
c. Life insurance companies have such a requirement because of the
adverse selection problem. Life insurance applicants know more about their
d. The answer is similar to part a. There is information asymmetry between
the seller and the buyers of the new share issue because the firm will know more
4. The financial press should provide a relevant source of information for investors.
The information provided by the financial press is not subject to the constraints
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5. a. One reason is that 1992 fourth quarter earnings came in lower than
expected by analysts and the market, and, for the whole year, earnings were
near the lower end of analysts’ forecasts. Since expected 1992 earnings would
b. The new earnings information, together with the market downturn,
apparently lowered investors’ expectations of GE’s future profitability and
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dividends. In terms of equation (4.2), the market’s expectation of (Pjt + Djt) fell.
Since, from equation (4.3), E(Rjt) is determined by Rf, βj and E(RMt), none of
6. If securities markets are efficient, lack of comparability of financial statements is
not important providing investors have sufficient information to quickly put
different firms’ information on a comparable basis and the costs of doing so are
low. For this, full disclosure, including disclosure of accounting policies used, is
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