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Chapter 3
The Financial Information
Marketplace
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 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, interest
rates, and other financial variables.
 To learn about the flow of funds accounts
and discover what is meant by “social
accounting.”
3-3
Introduction
 Sound financial decisions require
adequate and reliable financial
information
 Sources of information relied on by
financial decision makers





Debt security prices and yields
Stock prices and dividend yields
Information on security issuers
General economic and financial conditions
Social accounting data
3-4
The Great Debate Over
Efficient Markets & Asymmetric Information
 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.
3-5
The Great Debate Over
Efficient Markets & Asymmetric Information
 The other view is asymmetric information
 Pockets of inefficiency in information
availability
 Pockets of inefficiency in use of information
 Some market players possess better
information
 Can have special information
 Information may be costly for other parties
 Insiders can earn excess returns by
selectively trading financial assets based on
special information
3-6
The Great Debate Over
Efficient Markets & Asymmetric Information
 An efficient market
 Each individual investor will rationally use
all relevant information for valuation
 Neither wastes nor misuses information
 Do not systematically ignore
information to earn profits
3-7
The Great Debate Over
Efficient Markets & Asymmetric Information
 Financial markets today may have
many profit-maximizing, well-informed,
intelligent investors
 Won’t be profitable asset trades over time
 No systematic mispricing of assets
 Temporary deviation of actual returns from
expected should be quickly eliminated
 Each financial asset will generate an
ordinary, normal or expected rate of return
commensurate with its level of risk
3-8
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.
3-9
Different Forms of the EMH
 Evidence
 Subject to repeated research studies
 Tend to support the weak and semistrong
forms
 The strong form has aroused the most
controversy
 Existence of insider trading activities
 Apparent presence of pockets of special
information asymmetrically scattered
throughout the financial system
3-10
Insiders & Insider Trading
 Insiders
 People associated with the firm
 Information superior to general market
 Insider trading
 Buying or selling a financial asset
 Superior inside knowledge or privileges
 Manipulative or deceptive device in trading
forbidden
 Insiders not prohibited from trading
securities
3-11
Insider Trading Counterargument
Restrictions may hurt firm’s efficiency
 Discourage taking of risk
 Limit managerial incentive to perform
Businesses should decide
May improve market efficiency
 Encourages release of private information
 Prices correct more quickly
 Reduce risk to investor
3-12
Insider Trading Enforcement
Corporations monitor employee stock
trading
 Civil and criminal penalties
 Negative publicity
Difficult to get away with
 Greater surveillance
 Monitored by various parties
 Corporations
 Stock exchanges
 Security trading firms
3-13
The Asymmetric Information
Hypothesis (AIH)
Alternate hypothesis: Some
individuals and institutions have
access to pockets of information
concerning the true value and risk of
financial assets and others simply did
not
3-14
The Asymmetric Information
Hypothesis (AIH)
Pockets of special information
 Expertise
 Experience
 Location
Inefficient incentives
 Incentive to misrepresent quality of
information sold
 Information may lead to market
inefficiency
 Inconsistent with strong form efficiency
3-15
Problems 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 (low
quality) or plum (high quality).
3-16
Problems Informational
Asymmetries Can Create
Lender does not know customer quality
Customer has incentive to misrepresent if
low quality
Loan pricing reflects the likelihood of the
loan being low quality
 The pricing is above what a high quality
borrower should be charged
 High quality borrowers leave the market
Need a mechanism beyond pricing to
optimally allocate resources
3-17
Problems Informational
Asymmetries Can Create
 Adverse selection
 Asymmetric information before a contract
completed
 One party only chooses contracts that will
benefit self
3-18
Problems Informational
Asymmetries Can Create
Bank that sets one price for all
checking account customers
 High-balance, low-activity (and hence
most profitable) customers tend to
overpay and avoid contract
 Low-balance, high-activity customers
tend to underpay and prefer contract
 Solution: Enable customer signaling via
a conditional price schedule for different
account plans
3-19
Problems Informational
Asymmetries Can Create
 Moral hazard
 Asymmetric information after agreeing to a
contract
 One party in a contract may decide to
pursue its own self-interest at the expense
of the other party
 Poorly drafted contracts
 Ineffective monitoring activity
 Solution: Draw contracts with the
appropriate incentives
3-20
Asymmetry, Efficiency, &
Real-World Markets
 All real-world markets have elements of
both efficiency and asymmetry
 Perhaps real-world markets are split
into segments
 Highly efficient segment with wellinformed traders
 Less efficient segment with less-wellinformed small investors trade
3-21
Informational Asymmetries
and the Law
 Some laws and regulations are
designed to improve the flow of
information between
 Not always successful
 Unintended consequences
 Avoided by many non-corporate
participants
3-22
Informational Asymmetries
and the Law
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
3-23
Behavioral and Experimental
Behavioral and experimental finance
 Creating basic experiments to test behavior of
market participants
 Participants asked to make decisions in a
simplified economy
 Helps to isolate a single factor influencing the
markets
 Controls for others
 Unable to do in complexity of real economy
 Still a new and evolving field
3-24
Discovered Principals
Only the best-informed traders
appear to outperform less-informed
traders
Investors who purchase market
research information do not, on
average, achieve greater net returns
than investors who do not
3-25
Discovered Principals
Financial markets are able to
dispense information efficiently
through both verbal and nonverbal
communications(e.g. price and
volume)
Financial markets tend not to
gravitate toward those market
participants who assign the highest
value to those assets based on the
latest information
3-26
Sources of Information
Alternately sources abound to provide
information to investors
 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
3-27
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
3-28
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)
3-29
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
3-30
Sources of Information
Stock price indexes and foreign stock prices
 Data: stock indicies, index composition,
sector indicies, indicies by size, market-value
weighted indicies, international stock
markets, currency exchange rates
 Sources: computer networks (e.g. internet),
financial press, television, radio, financial
institutions (e.g. S&P, Wilshire), Federal
Reserve
3-31
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
3-32
Markets on the Net
 American Economic Association at
http://www.aeaweb.org
 Answers.com at answers.com/topic/random-walkhypothesis
 Bank of International Settlements at bis.org
 Bloomberg at bloomberg.com
 Bond Market Association at investinginbonds.com
 Bondsonline at www.bondsonline.com
 CNBC at www.cnbc.com
 Comptroller of the Currency at www.occ.treas.gov
 Computer Data Industry Association at
cdiaonline.org
3-33
Markets on the Net
 Dun & Bradstreet at www.dnb.com
 Economagic.com at economagic.com
 Euromoney.com at euromoney.com
 Equifax at www.equifax.com
 Experian www.experian.com
 Federal Deposit Insurance Corporation at
www.fdic.gov
 Federal Reserve at federalreserve.gov/releases
 Federal Reserve Bank of St. Louis at
research.stlouisfed.org/fred2
 FINIX European Stock Market Indices at
www.finix.at/
 Financial Times at www.ft.com
3-34
Markets on the Net
 International Monetary Fund at www.imf.org
 Investment Company Institute at www.ici.com
 Investopedia at
investopedia.com/university/concepts
 Investor Home at investorhome.com/emh.htm
 Money Magazine at money.cnn.com
 Moody’s Investors Service at www.moodys.com
 Morningstar at morningstar.com
 Motley Fool at fool.com
 MSN Money at moneycentral.msn.com
 New York Stock Exchange at www.nyse.com
3-35
Markets on the Net
 NASDAQ Stock Market at www.nasdaq.com
 Office of the Comptroller of Currency at
occ.treas.gov
 Quote.com at new.quote.com
 RePEc at ideas.repec.org
 Risk Management Associates at rmahq.org
 Securities and Exchange Commission at
www.sec.gov
 Social Science Research Network at
www.ssrn.com
 Standard and Poors Corporation at
stockinfo.standardpoor.com
3-36
Markets on the Net
 Stock Smart at stocksmart.com
 Transunion at www.transunion.com
 U.S. Department of Commerce at
www.doc.gov/
 U.S. Department of Treasury at
treasury.gov/press/releases
 Valueline at valueline.com
 Wall Street Journal at www.WSJ.com
 Wilshire 5000 index at www.wilshire.com
3-37
Chapter Review
 Introduction: 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
3-38
Chapter Review
 The great debate over efficient markets
and asymmetric information
 Problems informational asymmetries can
create
 Lemons and plums
 Adverse selection
 Moral hazard
 Asymmetry, efficiency, and real-world
markets
 Informational asymmetries and the law
3-39
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
3-40
Appendix
Social Accounting
3-41
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.
3-42
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.
3-43
National Income and Product Accounts
The Components of the U.S. GDP, 2006 ($ billions, current)
Source: U.S. Dept of Commerce and the Federal Reserve’s Flow of Funds Accounts
3-44
Flow of Funds Accounts
 Flow of Funds Accounts
 Traces the flow of savings
 Businesses, households and
governments
 Purchases of financial assets
 Show interaction of various parts of
financial system
 Highlight interconnections between the
financial sector and the rest of the
economy
3-45
Flow of Funds Accounts
Four basic steps of construction
 Sectoring the economy
 Building sector balance sheet
 Preparing sources and uses of funds
statements
 Building a flow of funds matrix for the
whole economy
3-46
Financial Assets and Liabilities
for the Household Sector
Source: The Federal Reserve’s Flow of Funds Accounts.
$ Billions, Outstanding at Year-End
3-47
Sources and Uses of Funds Statement
for the U.S. Banking Sector, 2006
Source: The Federal Reserve’s Flow of Funds Accounts. ($ Billions) *Annualized data from Q1. 3-48
Total Net Borrowing and Lending
in Credit Markets
Source: The Federal Reserve’s Flow of Funds Accounts. ($ Billions) **Annualized data from Q1.
3-49
Funds Raised in
Credit and Equity Markets
Source: The Federal Reserve’s Flow of Funds Accounts. ($ Billions) *Annualized data from Q1. 3-50
Flow of Funds Accounts
 Estimates useful for forecasting 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
3-51