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Lecture 12

BU457 Lecture 12: Measurement Approach REVIEW

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Wilfrid Laurier University
Bixia Xu

Measurement Approach REVIEW Measurement approach – approach to financial reporting under which accountants undertake a responsibility to incorporate current values into the financial statements proper, providing that this can be done with reasonable reliability, thereby recognizing and increased obligation to assist investors to predict firm performance and value. • If a measurement approach is to be useful for investors, increased relevance must outweigh any reduction in reliability • There has been a trend toward greater use of the measurement approach and this chapter looks at the possible reasons why • Securities market is not being considered as efficient as once thought • According to CAPM, beta is the only relevant risk measure, but there are other accounting variables, such as firm size and book-to-market ratio, that do a better job than beta of predicting share return. o This means that accountants should take more responsibility for reporting on firm risk • Security prices at times depart significantly from fundamental value. However, the important question for efficiency is whether securities prices reflect publicly available information o It can be concluded that securities market are close enough to full efficiency that the theory can serve as a guide to accountants Are securities markets fully efficient? • The average investor behaviour may not correspond with the rational decision theory and investment model • They may have limited attention (may not have the time, inclination, or ability to process all information o They may focus on information they know about such as bottom line and ignore info in the FS o They may also be conservative in their reaction to new evidence • Individuals may also be overconfident. They will overreact to information collected and understood themselves, and under react to information that may seem abstract • There is also representativeness where there is too much weight assigned to evidence that is consistent with the individual’s impression of the population from which the evidence is drawn. ] • Self-attribution bias is where individuals feel that good decisions outcomes are due to their abilities, where bad outcomes are unfortunate realizations of states of nature, hence not their fault. o Price momentum can develop when reinforced confidence following a rise in share price leads to purchase of more shares, therefore share prices rise further. • Motivated reasoning is where individuals accept information at face value that is consistent with their preferences. If they are inconsistent it is received with skepticism, and the individual attempts to discredit it. o Contrasts with the decision theory, where the decision-maker accepts objective probabilities of the information system, revising probabilities accordingly to GN or BN • All of the above reasons are examples of bahavioural-based securities market inefficiencies called behavioural finance. Prospect Theory • Behavioural-based alternative to the rational decision theory • An investor considering a risky investment will separately evaluate prospective gains and losses • Prospect Theory Utility Function, u(x) •These separate evaluations of gains and losses reflects the psychological concept of narrow framing o This is where individuals analyze problems in a too isolated manner • Prospect theory assumes loss aversion, where individuals dislike even the smallest of losses (see graph above) o This leads to the disposition effect where the investor holds onto losers and sells winners, then may even buy more loser • Prospect theory also assumes that individuals overweight or underweight their probabilities • Underweight comes from investor overconfidence, overweight comes from representativeness • The separate evaluation of gains and losses leads to a wide variety of irrational behaviours o Losses may cause investors to hold onto that stock so they don’t realize a loss Is Beta Dead? • Implication of CAPM is a stock’s beta is the sole firm-specific determinant of the expected return of that stock. • Farma and French (1992) found that beta, and thus CAPM, had little ability to explain stock returns o Instead they found that Book-to-Market ratio and firm size were more accurate risk measures than beta • There was a study from 1941-1990 that showed the relevance of beta in risk measure, but the difference was attributed to the time period studied and methodology used • Behaviour that is inconsistent with CAPM is viewed as evidence of market inefficiency. • Daniel, Hirshleifer, and Subrahmanyam model (2001) o Presents two types of investors – rational and overconfident o Rational investors lead a stocks beta to be positively related to its returns o Overconfident investors drive share price either too high or too low, therefore influencing the book-to-market ratio o Overtime the share price reverts to its efficient level as overconfidence is revealed • This theory proves that beta is subject to change • It can be concluded that beta is not dead, but may change over time Excess Stock Market Volatility • Higher expected aggregate dividends = more investors will invest in market • If the market was efficient, change in expected return on market portfolio should not exceed changes in expected dividends • Shiller (1981) found that variability of the stock market index was several times greater than the variability of aggregate demands o Interpreted as market inefficiency • This inefficiency can be explained by the behavioral factors o Daniel, Hirshleifer, and Subra implies excess market volatility as share prices overshoot and then fall back o Delong, Shleifer, Summers, Waldmann (1990) assume capital market has positive investors, those who buy shares when the price is on the rise. These investors jump on the bandwagon to take advantage of the price run up while it lasts, therefore leading to excess volatility in the market o It can be argued that since dividend is firm-specific, it has little influence on the market variability ▪ Ie. After the 2008 finacial meltdown, it was reported that there was no major cuts to dividends Stock Market Bubbles • When share price rise above fundamental values, represents extreme case of volatility • Bubbles form from positive feedback trading and “herd” behaviour reinforced by optimistic media predictions from market “experts” • Difficult to tell when a bubble will end • Security price behaviour leading up to the 2008 market meltdown was a bubble • Bubbles pose a serious challenge to market efficiency theory Efficient Securities Market Anomalies • There are two types of anomalies o Post-Announcement Drift ▪ Ideally info should be quickly digested and incorporated into the efficient market price ▪ This is not always the case, for GN in quarterly earnings, their abnormal security returns tend to drift upwards for some time following earnings announcement. Vice versa for BN ▪ This is reflected in the Ball & Brown study ▪ Quarterly season al earnings change is the expectations of current quarterly earnings are based off
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