Chapter 4 Flashcards
What is an efficient securities market?
A market where security prices fully reflect all available information
Why is market efficiency important?
It ensures that scarce capital is allocated to the most productive investments
How does financial reporting contribute to market efficiency
By converting inside information into publicly available information
What are the three forms of market efficiency?
Weak-form efficiency
Semi-strong form efficiency
Strong-form efficiency
What is weak-form efficiency?
Prices reflect past prices and volume only
What is semi-strong form efficiency?
Prices reflect all publicly available information
What is strong-form efficiency?
Prices reflect all public and private (inside) information
What form or efficiency is the most widely accepted?
Semi-strong form efficiency
What does semi-strong form efficiency imply for financial reporting?
New financial disclosures immediately affect stock prices
What is the main assumption behind market efficiency?
Investors rationally process information and adjust prices accordingly
What happens when a company releases good news under semi-strong efficiency?
The stock price increases immediately
What happens when a company releases bad news under semi-strong efficiency?
The stock price decreases immediately
Why is it impossible to consistently beat the market under semi-strong efficiency?
Because all public information is already incorporated into stock prices
What is the efficient market hypothesis (EMH)?
The idea that stock prices fully reflect all available information
What does the efficient market hypothesis (EMH) suggest about technical analysis?
It is useless because past price patterns cannot predict future returns
What doe the efficient market hypothesis (EMH) suggest about fundamental analysis?
It may be useless in semi-strong and strong-form markets, as stock prices already reflect all public information
What is the role of financial statements in an efficient market?
To provide timely and relevant information for investors
Why do financial statements matter if markets are efficient?
They ensure that all investors have equal access to public information
What happens if a company’s financial statements lack transparency?
It may create information asymmetry, leading to mispriced securities
What is information asymmetry?
A situation where some investors have more information than others
What are the two types of information asymmetry?
Adverse selection
Moral hazard
What is adverse selection?
Some investors have better access to information
What is moral hazard?
Managers may take actions that investors cannot observe
How does financial reporting help reduce adverse selection?
By ensuring that all investors have access to the same public information
How does corporate governance reduce moral hazard?
By ensuring managers act in shareholders best interests
Why do two similar firms with equal net income sometimes experience different stock price reactions?
Because the market considered more than just reported net income, such as:
Future growth potential
Industry trends
Management credibility
Quality of earnings
Why do stock prices reach differently to the same financial information?
Investors interpret financial data differently based on expectations and external factors
How does the financial press influence market reactions?
By shaping investor perceptions of financial information
Can investors consistently earn above-average returns in an efficient market?
No, unless they take on more risk
What is the best investment strategy in an efficient market?
Passive investing (index funds) since stock prices already reflect all available information
Why might active fund managers struggle to outperform the market?
Because stock prices already incorporate all known information
What is the relationship between risk and return in an efficient market?
Investors can only earn higher returns by taking on more risk
What happens to firm-specific risk in a diversified portfolio?
It is eliminated, leaving only systematic (market-wide) risk
Why do investors not get compensated for firm-specific risk?
Because it can be diversified away
How does market efficiency affect the choice of accounting policies?
As long as policies are fully disclosed, markets adjust for differences
Why does lack of comparability in accounting policies not necessarily affect share prices?
Investors can adjust for accounting differences if information is transparent
Why does full disclosure matter in an efficient market?
Because investors need complete and unbiased information to make decisions
What happens when insiders trade based on private information?
It creates information asymmetry, making the market less efficient
Why is insider trading illegal?
Because it gives certain investors an unfair advantage over others
What efficiency is it if only historical share prices are included?
Weak efficiency
What efficiency is it if all information is included, including inside information
Strong efficiency
What efficiency is it if all publicly available information is included?
Semi-strong efficiency
Is share price a reflection of what the company is worth?
No, it could include information that is incorrect or misleading when investors are calculating the share value, we don’t really know
Can you diversify away firm specific risk?
Yes, as long as you know what it is
Can you diversify away market risk?
No
What are examples of firm specific risk?
Currency risk, interest rate risk
