Information Asymmetry and EMH PDF

Information Asymmetry Why 1929 Crash? Frequent appraisal of capital assets (‘Historical Cost’ approach was not introduced). During great depression the values of these assets were fleeting. In most of the cases, crashes happened because of over valuation of assets (also called bubbles). So, t...

Information Asymmetry Why 1929 Crash? Frequent appraisal of capital assets (‘Historical Cost’ approach was not introduced). During great depression the values of these assets were fleeting. In most of the cases, crashes happened because of over valuation of assets (also called bubbles). So, the concept of Historical Cost Accounting (HCA) got importance. SEC vs Professionals SEC was proposing for standards of accounting. Professionals would have less chance of professional judgement. This led to a conflict between the SEC and professionals. SEC gave the professionals the duty of standard setting under the following conditions: Investors’ interest Proper operation of capital market. SEC vs Professionals However, during 1960s, the professional failed to justify ‘what is the best practice?’ (specifically practices during changing price and inflation) There is nothing called best practice. So, ‘Useful’ rather than ‘True’ information is needed. Need for Ethics and Regulation Collapse of Enron and WorldCom called for: Regulation (Sarbanes Oxley Act, 2002) Ethical Behavior of the accountants and auditors. Sarbanes Oxley Act: We cannot believe that regulation can give a complete protection to the investors. So ethics is also needed. Ethical behavior includes: Applying integrity and independence Putting public interest before everything Information Financial accounting environment is complex and challenging due to information that is useful to the stakeholders. Information is a commodity. A powerful and important commodity. Information affects: Individual decisions Operation of the market (Security Market and Managerial Labor Market) Information Asymmetry Some parties to business transactions may have an information advantage over others. No matter how much information managers provide to others, they know the best. There are two major types of information asymmetry: Adverse selection Moral Hazard Adverse Selection Adverse selection is a type of information asymmetry whereby one or more parties to a business transaction, or potential transaction, have an information advantage over other parties. Insiders have more knowledge about the current condition of the organization. Insiders may exploit this information at the expense of outsiders. Release of information can be ‘managed’ or be ‘biased’. Harms the ability of the investors to take good decisions. Adverse Selection There are two versions of the adverse selection problem. First, we have the problem of insider trading. If opportunities exist for insiders, including managers, to generate excessive profits by trading on the basis of their insider information, persons willing to do so will be attracted to the opportunity. Then, outside investors will not perceive the securities market as a level-playing field and may withdraw. This will reduce market liquidity. Adverse Selection A second version of adverse selection arises when managers who are privy to bad news about the firm’s future do not release that information, thereby, avoiding or at least postponing the negative firm consequences. This has two adverse effects: First, the investors are less able to distinguish between securities of different qualities. Second, since owners do not know that the bad news firm is doing badly, the ability of the takeover market to purge poor managers is reduced, so that the average quality of managers is lowered. Adverse Selection Tasks of accountants for adverse selection: Credible and timely information Creating a level-playing field through: Full Disclosure Useful Information Moral Hazard Moral hazard is a type of information asymmetry whereby one or more parties to a business transaction, or potential transaction, can observe their actions in fulfillment of the transaction but other parties cannot. Due to separation of ownership and control, it is almost impossible for shareholders and creditors to control management and to know about management actions. Management may relate low firm performance to outside/unavoidable factors. Moral Hazard We can then view accounting net income as a measure of managerial performance or stewardship. This helps to control moral hazard in two complementary ways: First, net income can serve as an input into executive compensation contracts to motivate manager performance. Second, net income can inform the manager labor market, so that a managers who shirks will suffer a decline in income, reputation and market value in the longer run. However, these processes may not be completely effective as managers may be able to disguise shirking by opportunistic earnings management. Efficient Market Hypothesis Efficient Market Hypothesis (EMH) In a competitive market, the equilibrium price (aggregate demand = aggregate supply) of any good or service depends on publicly available information. When new information becomes available, it gets interpreted by the market which can result in the possible changes in the existing equilibrium price. This equilibrium price holds until new information comes. Efficient Market Hypothesis (EMH) EMH: The primary hypothesis is that stock prices accurately reflect available information. If so, no amount of security analysis can consistently yield above-normal returns, and stock prices will adjust rapidly to new information. Whenever price reflects information, then there is not chance of overstating the assets. What is Market Efficiency? The rapidity and accuracy of price adjustments to new information. Those markets that adjust more rapidly and accurately to information, are considered more efficient. However, instantaneous price change is not possible. Market Efficiency and Accounting Securities market efficiency has important implications on financial accounting, specifically on the concept of full disclosure. It is information content of the disclosures, not the form of disclosure itself, that is valued by the market. It is to be remembered that format is not important, it is all about what information is there. What is an Efficient Market? A securities market is generally defined as efficient if: 1. The prices of the securities traded in the market act as though they fully reflect all available information, and 2. These prices react instantaneously or nearly so, and in an unbiased fashion to new information. It happens because of the existence of a group of professional investors who are capable of gathering, analyzing and interpreting all types of information on the companies whose securities are being traded. Levels of Market Efficiency According to Eugene Fama (1970), there are three levels of market efficiency: 1. Weak Form: Prices reflect past information 2. Semi-strong Form: Prices reflect all publicly traded information. 3. Strong Form: Prices reflect all (both private and public) information. Reasons for Market Inefficiency 1. Number of annual reports distributed is inadequate. 2. Experts and investors do not spend enough time for analysis. 3. Investors are naive. Testing EMH EMH is usually treated by examining deviation from expected return. But the major problem is: What constitute the expected return? There are two ways to test EMH: 1. Capital Asset Pricing Model (CAPM) 2. Arbitrage Pricing Model CAPM Assumptions of CAPM Assumption 1: This model is based on two things: 1. Investors have same investment horizon 2. Investors have same beliefs about the distribution of each security’s future return. Assumption 2: Investors’ preferences are based only on the mean (return) and variance (risk) of the distribution. Assumption 3: Investors are risk averse (they prefer a smaller variance of return). Assumption 4: Investors are able to borrow and lend an unlimited amount of risk-free security. Assumption 5: There is no transaction cost for the investor. Because of these assumptions, the CAPM remains controversial. Arbitrage Pricing Model (APM) According to APM, securities with identical returns will be priced the same. This theory combines existing assets to duplicate the return of the assets of interest. This is a multifactorial model. Criticisms: What are the factors? How many factors? Accounting and Market Efficiency Market efficiency has important impact on financial accounting, specifically on full disclosure. Information content of the disclosure are valued by the market. Information can be released through: Notes Supplimentaries Financial Statements These information has to compete with sources like news media, analysts and market prices. So, accounting will survive only it is relevant, reliable, timely and cost effective (in comparison to other resources). Accounting and Market Efficiency Accounting is also important for reducing information asymmetry. Accounting is a mechanism that enables communication of useful information from inside the firm to the outside. This results in improved operations of the securities market which leads to social benefits. Informed Investor and Market Efficiency Informed Investor and Market Efficiency Some investors spend considerable time and money to use the information sources to guide their investment decisions. There are ‘informed investors’ who will want to move quickly upon receipt of a new information. Otherwise others will use it and securities’ price will be adjusted. When ‘sufficient’ number of investors behave in this way, market becomes efficient (mostly semi-strong). Semi-strong Market In semi-strong market, price reflects all the publicly available information. There may be existence of insider information through which insiders can gain excess profit. Market efficiency is ‘relative’. Market prices can be wrong in the presence of insider information. Investing is a fair game if only the market is efficient. Securities market should fluctuate randomly over time which means there should not be serial correlation of share returns. Random Walk Theory Securities prices should fluctuate randomly over time. There should not be any serial correlation of share returns. If a news is released today, it should be reflected in the price ‘today’. If there is no further news, no changes in price in the succeeding periods should occur. How do Market Prices Fully Reflect All Available Information? The process is not obvious or transparent. Though rational investors will demand information, they may not behave identically due to prior belief and superior financial analysis expertise. Different investors may react to the same information differently (though rationally). However, individual differences are different. These differences average out and reduce bias. Market of Lemon When information asymmetry exists: In extreme case, market may collapse or fail to develop. In other case, the market does not work as well as it might (market of lemon). Even if the security price fully reflect all the information, the buyers may not be willing to pay that amount. Because they think that there exists insider information. This will result in the lack of investors’ confidence. Market of Lemon in History When Enron and WorldCom collapse happened there was a need for restoration of public confidence. Activities from the accountants to restore confidence were: Improving policies of full disclosure Expanding the set of information that is publicly available. Timeliness of reporting to the ability of insiders to profit from their information advantage. Thus, reducing possibility of adverse selection which resulted in improved operation of the share markets.