Part 7: Accounting Information and Asset Pricing Flashcards
Fama: sufficient but not necessary conditions of information efficiency
- no transaction costs
- information is available to all investors free of charge
- investors have homogeneous priors, they process information equally
Definition of informational efficiency from Fama
„A market in which prices always ‘fully reflect’
available information is called ‘efficient’.“
What does ‘fully reflect’ mean?
„Market efficiency requires that in setting the prices of
securities at any time t-1, the market correctly uses
all available information.“
Levels of informational efficiency
• weak
contains all market prices observable up to t-1.
F.e. Past market prices, what is observable
• semi-strong
contains all publicly available information up to t-1,
– which includes market prices.
– Problem: what is „publicly available“?
Not costly accounting information, income statement
• strong
contains all information up to t-1. Private information, like future strategy
– Problem: who knows all? We can never know everything
A weaker assumption is the possibility of unlimited arbitrage:
– As long as the marginal investor
– has the information available and
– faces no transaction costs,
– he is able to engage in arbitrage activities
– until his arbitrage trading strategy is not yielding any excess return.
Does accounting matter in informationally efficient markets?
• If markets are informationally efficient in a strong sense, (backward-looking)
accounting information might not be of any use.
• However, in reality, we usually assume that markets are informationally efficient
only in a semi-strong sense. In this world, accounting information should provide
new information content and does seem to do so – at least to some extent
Accounting in semi-strong informationally efficient markets
- Naive investors are price protected.
- Recognition versus disclosure does not matter.
• Accounting is one information source from a set of sources
– Other sources can be timelier and thus lead earnings.
– Accounting itself might have little valuation impact (it can still serve as a
verification device and disciplining instrument).
Rational expectations models ‘ impossibly of informationally efficient markets’
• Central assumptions:
– Investors possess homogeneous, but incomplete information.
– Additional information is available at cost.
– Investors behave rationally and, thus, can infer information from prices.
• Questions:
– Do investors choose to get informed?
– What is the equilibrium price?
What are the incentives to get informed?
In real life, markets will never be fully informationally efficient.
– The more efficient they become, the less incentives market participants have to acquire information.
– There is constant arrival of new information and
– constant change in information production cost.
– In addition, information production cost functions are heterogeneous.
• Thus, there will always be information asymmetry on (capital) markets.
• And there will always be an incentive to produce information and to impound it into prices:
Is information priced?
• Information on capital markets will never be complete.
• Financial accounting has the goal
– to increase the level of information (increase precision of information) and
– to level the playing field (lower information asymmetry).
Information precision in the CAPM-world
• In the CAPM-world, investors are homogeneous and as such there is no
information asymmetry between market participants but between
– nature who picks the attributes of the traded assets and
– market participants who have blurred knowledge about these attributes.
• This leads to the inability of market participants to estimate the expected return of
traded assets with optimal precision.
• We refer to this as sub-optimal information precision and assume that the lack of
precision is not causing a bias (i.e., it only influences the variance of expected
returns and not their mean).
• This is also labeled as estimation risk by the literature.
Information precision vs. information asymmetry
• An increase in information precision
(reduction of estimation risk) is priced if it has an impact on undiversifiable risk
components.
• In a large economy this is true if the precision increase has an impact on the
covariance of expected returns.
• If all investors are homogeneously informed,
– investors cannot learn from price and thus
– expected returns can be modeled without focusing on the price mechanism.
• If information precision is heterogeneously distributed across investors,
– information asymmetry arises and, in equilibrium,
– expected returns depend on price (rational expectations).
• Models of information asymmetry have to be rooted in the microstructure of the
capital market.
Asset pricing in a world with information asymmetry ( a market microstructure model)
• Easley and O’Hara (2004) develop a market microstructure model which
addresses the impact of information asymmetry on asset pricing.
• Building on a multi-asset noisy rational expectations framework,
• they assume two types of investors:
– an uninformed group receiving only public signals about assets and
– an informed group which receives additional private signals;
• where the total amount of signals is fixed.
Easley and O’Hara (2004): Results
- Uninformed investors can infer information from price, but only partially.
- Thus, they end up holding different portfolios than informed investors.
- As more investors get informed, information asymmetry is reduced,
- prices become more informative and
- the cost of capital is reduced.
Summing up…
• Informationally efficient markets seem to leave little reason for financial
accounting from a valuation perspective:
– Information is already priced.
– Financial accounting seems to be important to motivate truthfully self-
reporting by managers (contracting).
• But, producing and evaluating financial accounting information is costly:
– It appears rational to form expectations on price, to engage in piggy-back
riding on information evaluation by informed traders.
– Doubtful whether informationally efficient markets can exist in equilibrium.
