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Chapter 4:Efficient Securities Market
Group DTaylor Carson
Nicholas ChowMichael Cheuk-Hei Yu
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Meaning of
efficiency
Implications for
financial reporting
Full Disclosure
A capital asset
pricing model
Information asymmetry, insider
trading, adverse selection
Overview for Chapter 4
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Efficient Securities MarketsUnder ideal conditions, information is free
and investors use information to acquire and form subjective estimates of firms’ future performance
Realistically, information is not free and it is up to investors to form their own subjective estimates of firms’ future performance
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Efficient Securities Markets (con’t)Information sources include:
o Financial presso Tips from friends and associateso Changes in economic conditionso Advice from analysts and advisorso Quarterly and annual reports
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The Meaning of EfficiencyInformed investors will quickly move on
receipt of new information. If not, the market value of the security will adjust to reduce or eliminate the benefit
Two definitions of efficient securities market:Semi-strong form: reflects publicly available information
Strong form efficiency: reflects all information
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The Meaning of Efficiency (con’t)4 important points about efficiency:
1) Market prices are efficient with respect to publicly known information. Thus, prices do not consider inside information
2) The market is efficient relative to a stock of publicly available information.
3) Investing is fair game if the market is efficient
4) Given market efficiency, a security's market price should fluctuate randomly over time
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Decision theory allows different investors to react to the same information differently, even though they all proceed rationally
In the big picture, the differences in forecasting ability of individual forecasters tend to cancel out when the consensus is formed
Most importantly, the security values must on average by unbiased
Market prices reflect all available information
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Implications of efficient securities marketsi) Accounting policies adopted by firms do not
affect their security pricesii) If a firm’s management possesses relevant
information about the firm that can be disclosed at little or no cost, management should then disclose this information on a timely basis
iii) Financial statement information need not be presented in a manner so simple that everyone can understand it (naive investor)
iv) Accountants are in competition with other providers of information
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Logical Inconsistencyfully informative share prices allow
investors to stop gathering information and rely on markets price as the best indicator of future security returns
Investors acquire information
Investors loses motivation to acquire
information
Price fully reflect available information
Price doesn’t fully reflect available
information
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Informativeness of PriceLiquidity traders or noise traders buy/sell
decisions coming at random coming from a hot tip
Security prices are partially informative in the presence of noise trading
How informative the price is depends on the quality of financial statement information and costs of analysis and interpretation
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Informativeness of Price (cont’d)Voluntary disclosure: disclosure of
information beyond the minimum requirement of GAAP
Rational investor will then look at what the manager does in terms of accounting policy choice and disclosure
To increased the quality of financial statement disclosure, firms will include the management of discussion and analysis (MD&A)
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Capital Asset Pricing Models3 Main Uses:
Displays how share prices depend on expectations
Separate expected and unexpected components of realized return
Method to estimate a stock’s Beta
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Stock Prices Depend on Expectations
is the price of the shares at the end of the period
is the dividends paid by the firm is the price of the shares at the beginning of
the periodNew information changes , so must change
to balance out the formula
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Separate Expected and Unexpected Returns
is the beginning of period expected return is the unexpected return
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Estimate a Stock’s BetaObtain past data on and Perform a Least-squares regression and
obtain the model’s coefficientsThe coefficient of will be a good estimate of
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Information AsymmetryRoot cause of several market problems:
Failure to launchCollapseInefficiency
Why is it important to accounting theory?
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Fundamental Value vs. Market Value
Publicly Available
Information About
FirmInside
Information
Fundamental Value of Firm
Efficient Market Price of Firm
Role of Financial Reporting
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The Social Significance of Securities Markets that Work WellSecurities Markets = primary method
of raising capitalInformation asymmetry creates
problemsFrancis, Huang, Khurana, and Pereira
(2009)Easier to obtain financing in countries with high quality financial reporting
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Promoting Reporting QualityThere are two methods:
Regulations (stick)Incentives (carrot)
The right mix improves reporting quality
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Diminishing the Information Asymmetry
Management Discussion and AnalysisUsed to convey more information to the public
Summarize information from Financial Statements
Can include strategies, plans, and prospects
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Objectives of the MD&A
Investor
Company Performan
ce
Financial Condition Risks
Future Prospects
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Sun Airlines Inc.Operates primarily in the Eastern states and has
been profitable during each of the last 6 yearsOne of the first regional airlines to adopt a
frequent flyer plan (FFP) -> Sun Travel Award Club (STAC)
In 2002, approximately 45% of paid-for revenue passenger miles were eligible for FFP rewards to FFP members
SAI has had a deteriorating current ratio and is approaching the minimum required by their lender’s covenants
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Sun Airlines Inc.After today’s textbook overview, what is one
major implication of the possible covenant violation?
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Sun Airlines Inc.The FFP is causing a liability on the balance
sheet and some VPs would like to see it removed
Marketing is refusing to have it eliminatedInvestor relations is suggesting that this
should be a contingency and therefore buried in the notes as opposed to set up as a liability
What do you think?
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Sun Airlines Inc.2 methods for accounting for FFPs - criteria
Incremental cost method: assumes no displacement of revenue paying customers and that the earnings process is complete when the paid flight is taken, the no displacement is often shown by blackout periods and capacity controls, available excess capacity, and the FFP awards using a small portion of the excess
Deferred revenue method: the free travel awards are essentially considered discounted tickets, it is suggested that this is used at least for the routes on which the load factor is high
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Sun Airlines Inc.2 methods for accounting for FFPs – effects
Incremental cost method: a liability is set up for the expected incremental cost of having the extra passengers on a future flight – takes into account an estimate of outstanding miles expected to be redeemed
Deferred revenue method: a portion of the revenues received for current flights is deferred until the free flight is taken in the future in order to essentially spread the revenue across all flights taken
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Sun Airlines Inc.Given that Sun Airlines has current
passenger load factors in the 60-70% range, that they provide a blackout period around holidays and other peak periods, what method should be used?
One of the VPs mentioned that overall there is extra capacity, but certain routes operate close to 100% capacity, does this change your answer?
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Sun Airlines Inc.Given the current state, the current ratio has
dropped to ~ 0.739 which is less than the required 0.8, causing a current covenant violation
If the STAC liability were to be eliminated, the current ratio would move to ~ 0.864. However, this would require the elimination of the FFP program, which would cause many other issues, including potential lawsuits and loss of customers
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Sun Airlines Inc.Currently using a 75% expected redemption
based on historical dataHowever, VP Operations expects that in the
future, only 70% of the miles flown by FFP members will qualify for rewards
What concept previously discussed does this relate to?
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Sun Airlines Inc.Other issue facing the company is the
revenue recognition surrounding bulk miles sold to other companies that can be returned. There is likely a marketing component as well as the travel portion, and therefore a travel portion should be removed if possible.
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Mid-Term Prep Questions6. What market efficiency means?7. Why the term “market efficiency” is important
to financial accounting?8. How market efficiency occurs?9. How Market inefficiency can have impacts on
financial accounting?10. What are the market anomalies? What they
indicate?11. What information asymmetry means? What
consequences can it cause? How is it related to market efficiency?