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Chapter 3 The Financial Information Marketplace 3-3 Learning Objectives • To identify important sources of information about the financial system. • To understand why the efficient distribution of information within the financial system is so important. • To learn how market participants keep track of the prices of financial assets. • To learn about the flow of funds accounts and discover what is meant by “social accounting.” McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-4 Introduction • Sound financial decisions require adequate and reliable financial information. • We may divide the sources of information relied on by financial decision makers into: debt security prices and yields, stock prices and dividend yields, information on security issuers, general economic and financial conditions, and social accounting data. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-5 The Great Debate Over Efficient Markets & Asymmetric Information • The efficient markets hypothesis (EMH) contends that information relevant to the pricing (valuation) of loans, securities, and other financial assets is readily available to all borrowers and lenders at negligible cost. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-6 The Great Debate Over Efficient Markets & Asymmetric Information • On the other hand, the concept of asymmetric information argues that the financial marketplace contains pockets of inefficiency in the availability and use of information, such that insiders can earn excess returns by selectively trading financial assets based on the special information they have been able to acquire. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-7 The Great Debate Over Efficient Markets & Asymmetric Information • In an efficient marketplace, each individual investor will rationally use all the relevant information that is available to value stocks and bonds. • Hence, each financial asset will generate an ordinary, normal or expected rate of return commensurate with its level of risk. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-8 The Great Debate Over Efficient Markets & Asymmetric Information • If the EMH holds, any temporary deviation of actual returns from expected returns should be quickly eliminated as investors react to temporary underpricing or overpricing of assets. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3-9 Different Forms of the EMH • The weak form of the EMH argues that the current price of a financial asset already reflects all its price and trading volume history. • The semistrong form contends that the current price of a financial asset already reflects all publicly available and relevant information. • The strong form argues that the current price of a financial asset already captures all relevant public and private information. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 10 Different Forms of the EMH • Repeated research studies tend to support the weak and semistrong forms of the EMH. • The strong form, however, has aroused the most controversy, especially because of the existence of insider trading activities and the apparent presence of pockets of special information asymmetrically scattered throughout the financial system. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 11 Insider Trading & Asymmetric Information • Insider trading refers to buying or selling a financial asset based on special knowledge or privileges, before that privileged information becomes publicly known. • Asymmetric information refers to the inequalities in the quantity and quality of information available across different locations within the financial system. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 12 Problems Informational Asymmetries Can Create • Lemons and Plums. A loan officer (buyer) cannot be sure without incurring substantial costs whether his or her potential customer (seller) is a lemon (sour) or plum (sweet). - A mispricing may cause plums to be driven away from the market. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 13 Problems Informational Asymmetries Can Create • Adverse Selection. A bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its high-balance, low-activity (and hence most profitable) customers. - Solution: Enable customer signaling via a conditional price schedule for different account plans. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 14 Problems Informational Asymmetries Can Create • Moral Hazard. One party to a principal-agent contract may decide to pursue its own self-interest at the expense of the other party, often because of poorly drafted contracts or ineffective monitoring activity. - Solution: Draw contracts with the appropriate incentives so that agents will want to act more in line with the interests of principals. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 15 Asymmetry, Efficiency, & Real-World Markets • All real-world markets have elements of both efficiency and asymmetry. • Perhaps, real-world markets are split into segments: A highly efficient segment in which well-informed individuals and institutions trade. A less efficient segment in which less-well-informed small investors trade. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 16 Informational Asymmetries and The Law • Some laws and regulations are designed to improve the flow of information between buyers and sellers and to protect the public against deception in valuing financial assets. • U.S. examples: - 1934 Securities Exchange Act 1940 Investment Company Act 1970 Securities Investor Protection Act Regulation FD (Fair Disclosure), 2000 2002 Sarbanes-Oxley Accounting Practices Act McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 17 Sources of Information Debt Security Prices and Yields • Data: bid & ask prices, yields-to-maturity Sources: real-time computer networks (e.g. Reuters, Bloomberg), televised reports (e.g. CNN, CNBC), financial press (e.g. The Wall Street Journal) • Data: bond yield indexes Sources: Moody’s Investor Service, The Daily Bond Buyer, U.S. Treasury, Dow Jones McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 18 Sources of Information Indicators of Average Bond Yields (Average Annual Yields in Percent) Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, selected issues McGraw-Hill/Irwin *2004 figures for January Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 19 Sources of Information Stock Prices and Dividend Yields • Data: prices (year-high, year-low, day-high, day-low, closing), sales volume, most recent dividend, dividend yield, P-E ratio, stock price indexes (e.g. DJIA, S&P500, Wilshire 5000), foreign stock prices Sources: computer networks (e.g. Internet), financial press, television, radio, financial institutions (e.g. S&P, Morningstar) McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 20 Sources of Information Security Issuers • Data: firm history, principal products/services, key officers, recent operation summary, financial statements, credit ratings, industry performance indicators Sources: regulatory agencies (e.g. SEC), trade associations, commercial institutions (e.g. Moody’s, S&P, Dun & Bradstreet), directories & databases, journals & magazines, credit bureaus McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 21 Sources of Information General Economic and Financial Conditions • Data: interest rates, money supply measures, industrial output, international transactions, unemployment rate, inflation, forecasts Sources: central banks (e.g. the Federal Reserve), statistical bureaus (e.g. Bureau of Economic Analysis), financial press McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 22 Social Accounting Data • Social accounting refers to the system of record keeping that reports transactions between the principal sectors of the economy, such as households, financial institutions, corporations, and units of government. • The two most closely followed social accounting systems in the U.S. are the National Income and Product Accounts and the Flow of Funds Accounts. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 3 - 23 National Income and Product Accounts • The National Income and Product Accounts (NIPA) present data on the nation’s production of goods and services, income flows, investment spending, consumption, and savings. • In particular, the gross domestic product (GDP) measures the market value of all goods and services produced in the economy within its geographical boundaries. McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.