Efficient Market and the Information Perspective

1
Efficient Market and the Information Perspective

• Week 3

2
Agenda for Today

• Project guidelines
• Chapter 4
• Efficient markets quick review
• Discussion of beaver (1993) paper
• Some technical aspects of efficient markets
• Chapter 5
• Review
• Ball and brown
• Ou and penman

3
Project Guidelines

• Type of project.
• Critical analysis and discussion.
• Literature review.
• Hypothetical cases.
• Empirical study.
• Case study.
• Length suggested around 10 pages.
• Organized headings, sub-headings, points, list
  of references, etc.

4
Some Suggested Topics

• Critique of some recent standards or proposed
  standards
• Gray areas in standard-setting
• Accounting for hedges and derivatives
• Accounting for executive stock options
• Accounting and ethics
• Fraud detection, malpractice versus complexity
• Corporate governance issues

5
Marking will be guided by

• Internal consistency and logic
• Presentation (but substance over form)
• Extensiveness of literature review
• Application of theory from class and textbook
  (where applicable)

6
Efficient markets

• Markets in which prices reflect all publicly
  available information.
• Publicly known information only
• a relative concept (efficient markets are not
  God)
• investing is a fair game (over time, prices
  fluctuate randomly from their expected values)

7
Why are markets efficient ?

• Why can you make money by consistently betting on
  the favorite ? (or look at Table 4-1 example)
• Errors made by different forecasters tend to be
  in different directions.

8
Beaver (1973) what should be the FASBs
objectives

• Important paper guiding the U.S. framework
  development
• Considers this problem If markets are efficient,
  what should be the goal of standard-setting?
• Evidence of efficiency
• Prices react quickly
• P/E s higher for A/A firms than for A/S firms,
  but same when consistent method used
• Mutual funds cant beat the market consistently

9
Implications for standard-setting

• First, dont waste resources on issues where
  users can adjust from one method to another given
  sufficient information. Just require one method
  and ask for footnote disclosure of the other.
• Statement of accounting policies
• Second, use greater disclosure.
• Accountants can be held liable for poor
  disclosure, but not wrong methods.
• Third, dont worry about the naïve investor.
• Fairly represent risk. Dont obscure volatility
  by making numbers more smooth.

10
Implications for standard-setting

• Fourth, dont assume that financial statements
  need to provide everything an investor needs.
  There are competing sources.

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Cost of Poor Financial Information

• Cost due to insider trading (asymmetric
  information).
• Excessive information costs.
• No accounting disclosure that is more expensive
  to disclose elsewhere.
• Accounting disclosure that is cheaper to disclose
  elsewhere.
• Disclosure of information that is very costly to
  disclose relative to its usefulness (FASB 109
  --deferred tax?).

12
Are markets really efficient?

• If prices reflect all information, why bother to
  collect information?
• If nobody bothers to collect information, how
  would prices reflect it?
• Noise traders
• Information asymmetry (the market for lemons, the
  insurance industry)

13
Ou and Penman

• Fundamental analysis should lead to
  better-than-market returns.
• Because it adds information
• Approach
• Compute a future earnings power measure Pr by
  running a (logistic) regression of earnings
  increase or decrease dummies on lots of ratios
  (68). This creates a score (narrowed down to 16
  or 18 ratios).
• Use the score to develop a trading strategy.
  (long for Pr gt 0.6 and short for Pr lt 0.4)
• Results
• Cumulative abnormal returns of 20 over 36
  months.

14
How to deal with the information asymmetry
problem ?

• Market regulation (e.g., penalties for insider
  trading)
• IF NO REGULATION
• voluntary disclosure (signaling)
• full disclosure
• BUT ARE THESE CREDIBLE ?

Credible full disclosure
15
Some other implications

• Future oriented disclosures
• Timeliness
• ...

16
Revision of SSAP 5

• Why is SSAP 5 necessary?
• Why is the revision necessary?
• Objective to bring Hong Kong standard practice
  in line with IAS 33.

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Principal Effects of Revision

• Extraordinary items included in numerator
• Non-ranking shares included in denominator
• Changes in diluted EPS calculation (e.G., Because
  of different treatment for dilutive options)
• Post-balance sheet splits
• Diluted EPS must be reported

18
Group Exercise
19
Some Technical Aspects

• Return
• holding gains per share between some dates t and
  t1
• net vs. gross
• expected (ex ante) vs. realized (ex post)

20
Sharpe-Lintner CAPM
21
Review of Chapter 5

• Ball and Brown
• Levels vs. changes
• ERCs

22
Ball and Brown
Short-window vs. long window
Short-window results
Returns are CUMULATIVE
Market anticipated GN / BN
Drift
-12
0
6
23
Levels vs. Changes

• We can look at the association between returns
  (say over one year) and earnings levels OR
• We can look at the association between unexpected
  returns and unexpected earnings (or earnings
  changes).

24
ERCs

• beta
• capital structure
• persistence
• permanent, transitory, price-irrelevant
• conservatism and the asymmetric timeliness of
  earnings
• Earnings quality
• Growth opportunities
• Size

25
Chapter 5 Review (Contd.)

• Example of Implication Extraordinary items and
  classificatory smoothing
• unusual and infrequent
• Accounting risk measures and beta
• dividend payout (-ve)
• leverage (ve)
• earnings variability (ve, very strong)
• Accounting beta (ve)

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Exceptional Items

• SSAP 2 (old)
• Extraordinary items non-operating and infrequent
• Exceptional items part of ordinary income but
  separately disclosed

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Model 1
-0.045
0.080
28
Model 2
-0.05
0.09
0.06
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Model 3
0.04
0.18
0.18
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Questions From Chapter
4. 6. 7. 8.10. 16.