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Chapter 3
The Financial
Information Marketplace
3-2
 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.”
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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
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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
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*2004 figures for January
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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)
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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
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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
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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.
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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.
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National Income and Product Accounts
The Components of the U.S. GDP, 2004* ($ billions, current)
Source: U.S. Dept of Commerce and the Federal Reserve’s Flow of Funds Accounts
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of 2004
and annualized
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Flow of Funds Accounts
• The Flow of Funds Accounts

trace the flow of savings by businesses, households,
and governments into purchases of financial assets;

show how the various parts of the financial system
interact with each other; and

highlight the interconnections between the financial
sector and the rest of the economy.
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Flow of Funds Accounts
• The construction of the Flow of Funds Accounts requires four
basic steps:

Sectoring the economy

Building sector balance sheets
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Statement of Financial Assets and Liabilities
for the Household Sector
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Statement of Financial Assets and Liabilities
for the Household Sector
… continued
Source: The Federal Reserve’s Flow of Funds Accounts.
$ Billions, Outstanding at Year-End *Figures are for Q1 of 2004 & annualized.
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Flow of Funds Accounts
• The construction of the Flow of Funds Accounts requires four
basic steps:

Sectoring the economy

Building sector balance sheets

Preparing sources and uses of funds statements
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Sources and Uses of Funds Statement
for the U.S. Banking Sector, 2004*
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Source: The Federal Reserve’s
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Flow of Funds Accounts. ($ Billions) *Annualized data from Q1.
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Flow of Funds Accounts
• The construction of the Flow of Funds Accounts requires four
basic steps:

Sectoring the economy

Building sector balance sheets

Preparing sources and uses of funds statements

Building a flow of funds matrix for the whole
economy
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Total Net Borrowing and Lending in Credit Markets
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Money and
CapitalThe
Markets,
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Source:
Federal
Reserve’s Flow of Funds Accounts.
Billions) Companies,
**Annualized
from
Q1.
© 2006 The ($
McGraw-Hill
Inc., Alldata
Rights
Reserved.
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Total Net Borrowing and Lending in Credit Markets
… continued
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Funds Raised in Credit and Equity Markets
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TheMarkets,
Federal9/eReserve’s
MoneySource:
and Capital
Flow of Funds Accounts.
($ Billions)
data
© 2006 The
McGraw-Hill*Annualized
Companies, Inc.,
All from
RightsQ1.
Reserved.
3 - 34
Flow of Funds Accounts
• Estimates of flow of funds data can be used to help make
forecasts of lending, borrowing, and interest rates.
• However, these social accounts do have a number of
limitations:
- Transactions among economic units within each sector are not
captured.
- Flows that occur within the time period under study are not
captured.
- The market-value bias of the data distorts actual savings and
investment activity.
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Markets on the Net
•
•
•
•
•
American Economic Association at http://www.aeaweb.org
Comptroller of the Currency at www.occ.treas.gov
Dun & Bradstreet at www.dnb.com
Federal Deposit Insurance Corporation at www.fdic.gov
FINIX European Stock Market Indices at www.finix.at/
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Markets on the Net
•
•
•
•
•
International Monetary Fund at www.imf.org
Investment Company Institute at www.ici.com
Moody’s Investors Service at www.moodys.com
New York Stock Exchange at www.nyse.com
The NASDAQ Stock Market at www.nasdaq.com
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Markets on the Net
•
•
•
•
•
Securities and Exchange Commission at www.sec.gov
The Bond Market Association at www.investinginbonds.com
The Financial Times at www.ft.com
The Wall Street Journal at www.WSJ.com
U.S. Department of Commerce at www.doc.gov/
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Chapter Review
• Introduction: The Importance of Information in the Financial
Marketplace
• The Great Debate Over Efficient Markets and Asymmetric
Information
- The Efficient Markets Hypothesis (EMH)
• What Is An Efficient Market?
• Different Forms of the EMH
• Insiders and Insider Trading
- The Concept of Asymmetric Information
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Chapter Review
• The Great Debate Over Efficient Markets and Asymmetric
Information … cont
- Problems Informational Asymmetries Can Create
• Lemons and Plums
• Adverse Selection
• Moral Hazard
- Asymmetry, Efficiency, and Real-World Markets
- Informational Asymmetries and the Law
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Chapter Review
• Sources of Information
-
Debt Security Prices and Yields
Stock Prices and Dividend Yields
Security Issuers
General Economic and Financial Conditions
• Social Accounting Data
- National Income and Product Accounts
- The Flow of Funds Accounts
McGraw-Hill/Irwin
Money and Capital Markets, 9/e
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.