Transcript Chapter 3
3 Chapter Key Sources of Financial Information Money and Capital Markets Financial Institutions and Instruments in a Global Marketplace Eighth Edition Peter S. Rose McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu 3-2 Learning Objectives To identify important sources of information about the global financial system. To understand why the efficient distribution of information within the financial system is important. To learn how market participants keep track of the prices of financial assets. To learn about the content and concepts behind the main social accounting systems. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3-3 Introduction Sound financial decisions require adequate and accurate 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 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3-4 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 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3-5 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 assets based on the special information they have been able to acquire. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3-6 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 or normal rate of return commensurate with its level of risk. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3-7 Efficient Markets & Asymmetric Information According to the capital asset pricing model (CAPM), the expected return on financial asset (or portfolio of assets) i, E(Ri), is: ERi rF β i ERM rF The CAPM indicates that E(Ri) depends on rF, the time value of money (risk-free interest rate) E(RM) – rF, the reward for bearing systematic risk i, McGraw Hill / Irwin asset i’s level of systematic risk 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3-8 Efficient Markets & Asymmetric Information The line or curve described by the CAPM equation is usually called the security market line (SML). E(Ri) RM SML market portfolio M rF 0 McGraw Hill / Irwin 1.0 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3-9 Efficient Markets & Asymmetric Information If the EMH holds, any temporary deviation of actual returns from the SML should be quickly eliminated as investors react to temporary underpricing or overpricing of assets. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 10 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 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 11 Different Forms of the EMH Repeated research studies have essentially confirmed the weak and semistrong forms of the EMH. The strong form, however, has been the most controversial, especially because of the existence of insider trading activities and because of the apparent asymmetrical scattering of pockets of special information throughout the financial system. McGraw Hill / Irwin 2003 by 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). Result: Plums may be driven away from the market. McGraw Hill / Irwin 2003 by 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: Enabling customer signaling via a price schedule for different account plans. McGraw Hill / Irwin 2003 by 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 selfinterest at the expense of the other party. Solution: Contracts drawn with the appropriate incentives and monitoring. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 15 Asymmetry, Efficiency, & Real-World Markets All real-world markets seem to have elements of both efficiency and asymmetry. Perhaps, real-world markets can be split into two segments: A highly efficient segment in which well-informed individuals and institutions trade. A market segment in which less-well-informed small investors and small businesses trade. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 16 Possible Remedies for Informational Asymmetries 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. Examples (U.S. ): 1934 Securities Exchange Act 1940 Investment Company Act 1970 Securities Investor Protection Act Regulation FD (Fair Disclosure), 2000 McGraw Hill / Irwin 2003 by 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 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 18 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), foreign stock prices Sources: computer networks (e.g. Internet), financial press, television, radio, financial institutions (e.g. S&P, Morningstar) McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 19 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 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 20 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 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 21 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 Accounts and the Flow of Funds Accounts. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 22 National Income Accounts The National Income Accounts (NIA) present data on the nation’s production of goods and services, income flows, investment spending, consumption, and savings. In particular, the level and growth of the nation’s economic activity is summarized by the gross national product (GNP) and gross domestic product (GDP). McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 23 Sample Table from the U.S. National Income and Product Accounts (NIPA) Source: http://www.bea.gov National Income Accounts 3 - 24 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. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 25 Flow of Funds Accounts The construction of the Flow of Funds Accounts requires four basic steps: Sector the economy. Construct sector balance sheets. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 26 Sample Balance Sheet from the U.S. Flow of Funds Accounts Flow of Funds Accounts Source: http://www.federalreserve.gov 3 - 27 Flow of Funds Accounts The construction of the Flow of Funds Accounts requires four basic steps: Sector the economy. Construct sector balance sheets. Prepare a sources and uses of funds statement for each sector. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. Sample Sources and Uses of Funds Statement from the U.S. Flow of Funds Accounts Flow of Funds Accounts Source: http://www.federalreserve.gov 3 - 28 3 - 29 Flow of Funds Accounts The construction of the Flow of Funds Accounts requires four basic steps: Sector the economy. Construct sector balance sheets. Prepare a sources and uses of funds statement for each sector. Construct a flow of funds matrix for the economy as a whole. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. Sample U.S. Flow of Funds Matrix Flow of Funds Accounts Source: http://www.federalreserve.gov 3 - 30 3 - 31 Money and Capital Markets in Cyberspace Most key institutions provide extensive online information. Visit, for example, the Federal Reserve at http://www.federalreserve.gov and the Securities and Exchange Commission at http://www.sec.gov. Or link to worldwide central banks from http://www.bis.org/cbanks.htm. Many financial institutions have also made it easier to track money and capital market movements. Visit, for example, Money Magazine’s http://money.cnn.com/. McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 32 Chapter Review Introduction Efficient Markets and Asymmetric Information The Efficient Markets Hypothesis (EMH) • The Security Market Line (SML) • Different Forms of the EMH Insiders and Insider Trading The Concept of Asymmetric Information McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 33 Chapter Review Efficient Markets and Asymmetric Information … cont Problems Informational Asymmetries Can Create • Lemons and Plums • Adverse Selection • Moral Hazard Asymmetry, Efficiency, and Real-World Markets Possible Remedies for Informational Asymmetries McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved. 3 - 34 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 Accounts Flow of Funds Accounts McGraw Hill / Irwin 2003 by The McGraw-Hill Companies, Inc. All rights reserved.