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Chapter 4

Chapter 4 – Efficient Securities Markets.docx

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Keith Whelan

Chapter 4 – Efficient Securities Markets The Meaning of Efficiency • Investors decide how much accounting expertise and information to acquire to form conclusions on a firm’s future performance o Rational investors continuously reassess their beliefs as new information becomes available • Each investor faces a cost-benefit analysis as to how much info to gather o Leads to inefficiency as some investors may not gather a sufficient amount • Informed investors spend considerable time and money to gather appropriate information – what about uninformed? Leads to inefficiency • When a sufficient number of investors act quickly when new info becomes available, market is said to be efficient • *** Semi-strong form efficiency: market prices at all times reflect all information that is public • Strong-form efficiency: securities prices reflect all information, even if not public – not likely • Market efficiency is relative to the stock of publicly available information o Market efficiency does not guarantee stock price will reflect firm value – as it is based on the stock of info o Is it efficient based on the information that is publicly available? – The only way we can gauge  This theory therefore does not rule out the implications of insider information • Investing is a fair game if the market is efficient o Investors cannot expect to earn excess returns over and above the normal expected return on that security, where the normal expected return allows for risk • Given market efficiency, a security’s market price should fluctuate randomly over time – random walk o Expected events are built into share price (seasonality, change of leadership, etc.) o The only reason that prices will change is if some relevant, but unexpected information comes along, which occurs randomly  Supporting efficient markets: if good news comes out, price should reflect it on that day  Supporting inefficient markets: if the days after the good news, the price continues to rise without any new information coming fourth How do Market Prices Reflect AllAvailable Information • All investors have different perceptions of what is rational, which causes them to react differently o In effect, market price may not fully reflect all public info as people will make different buy/sell decisions based on it • For the price to fully reflect all public info, investors must use all public info • In efficient securities markets, prices fully reflect all public info and the price changes will behave randomly over time Implications of Efficient Securities Markets for Financial Reporting 1. Managers and accountants should not be concerned about which accounting policies they use, unless they have a direct effect on cash flows 2. Firms should disclose as much information about themselves as long as the benefit to investors exceeds the costs a. Must give information in a timely manner, unless investors are provided with it from a different source – investor
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