CHAPTER SIX: ANALYSIS OF INFORMATION STRUCTURE ON THE FIANANCIAL MARKET

The Importance of Market Efficiency Understanding the If and How the EMH Principal can Affect Shareholder Wealth • Understanding how securities are valued is important because these valuation principles provide guidelines to managers how they should manage businesses on behalf of the shareholders. • It is the legal requirement and managerial responsibility for managers to act in the owners’ best interest. • The discount rate that represents shareholder’s required rate of return is established as a result of benchmark rates in the capital markets such as the Risk-Free Rate (RF) and the market risk premium....
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CHAPTER SIX: ANALYSIS OF INFORMATION STRUCTURE ON THE FIANANCIAL MARKET CHAPTER SIX: ANALYSIS OF INFORMATION STRUCTURE ON THE FIANANCIAL MARKET 06/08/2011 1 The Importance of Market Efficiency Understanding the If and How the EMH Principal can Affect Shareholder Wealth • Understanding how securities are valued is important because these valuation principles provide guidelines to managers how they should manage businesses on behalf of the shareholders. • It is the legal requirement and managerial responsibility for managers to act in the owners’ best interest. • The discount rate that represents shareholder’s required rate of return is established as a result of benchmark rates in the capital markets such as the Risk-Free Rate (RF) and the market risk premium. • A question remains…DO MARKET PRICES REFLECT THE ACTIONS OF MANAGERS? – If they do, then managers must learn what actions they should take in order to fulfill their legal and managerial responsibilities to shareholders. 06/08/2011 2 The Importance of Market Efficiency Three Elements to Market Efficiency • Operational Efficiency – Transactions costs are low, thereby enhancing trading of securities • Allocational Efficiency – There are enough securities to efficiently allocate risk • Informational Efficiency – Market prices fairly and quickly reflect all available information. 06/08/2011 3 The Importance of Market Efficiency Informational Efficiency • Informational Efficiency is the focus of this chapter. • The closer the link between actions of managers and the value of the firm, the more informationally-efficient the capital market. 06/08/2011 4 The Importance of Market Efficiency Securities Laws Affecting Public-Issuers of Securities Securities laws in Canada reflect the belief that there is (or should be) a strong connection between information and stock prices and these laws reflect a number of common principles related to parties to transactions and access to information: – Continuous disclosure of all material information about the firm. • Publicly-traded firms fulfill this responsibility through publication of annual audited financial statements, unaudited quarterly financial statements, and through timely press releases and announcements of anything that could ‘materially’ affect the share price of the firm. – Fair and equal treatment of all market participants through disclosure requirements that ensure all participants have simultaneous access to the same information about publicly-traded firms. • The use of cease-trading orders when new information is being released to the market is an example of how regulators ensure that information is widely disseminated to all market participants before trading is allowed to occur. In this way, all market participants are trading on the basis of the same and complete information ensuring that some participants do not have an informational advantage over others. 06/08/2011 5 Asymmetric Information • Asymmetric information is when one party to a transaction has access to more a complete and accurate set of facts than the other party. – When this condition exists, it is possible for the party with better information to use that at their own personal gain, and at the expense of the other. 06/08/2011 10 - 6 Asymmetric Information An Example – The Used Car! An example of Asymmetric information from everyday life might be the situation between a buyer and seller of a used car in a private transaction. – The seller has intimate knowledge of recent car history including past owners, collisions, repairs, and problems. – The buyer (presuming no expertise as a mechanic) has only their limited skills of observation and investigation to inform their purchase decision. In the foregoing example, it is possible, in the absence of rules and regulations, for the seller to take advantage of the buyer because of information asymmetry. This means, the buyer is likely to pay more for the car than they should! The seller reaps the rewards of superior information. In some provinces, before such a transaction can occur, a sellers information package must be obtained from the Ministry of Transportation. This package will include an estimate of wholesale and retail price of the used car, and a list of past owners. This is an example of government regulation to try to reduce the information advantage sellers have over buyers. 06/08/2011 7 Disclosure and Market Efficiency The Asymmetric Information Challenge • If informational advantages were widely permitted, and if there were a persistent advantage of some market participants over others, the credibility of the markets would be shaken. • Under such circumstances, many people would choose not to invest in securities, choosing, instead to put their money into managed deposits, or worse, choosing to hide their money under a pillow. • This would significantly reduce the number of market participan ...