Money and Capital Markets3 C h a p t e rEighth EditionFinancial Institutions and Instruments in a Global MarketplacePeter S. RoseMcGraw Hill / IrwinSlides by Yee-Tien (Ted) FuKey Sources of Financial Information 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin3 - 2 Learning Objectives w To identify important sources of information about the global financial system. w To understand why the efficient distribution of information within the financial system is important. w To learn how market participants keep track of the prices of financial assets. w To learn about the content and concepts behind the main social accounting systems. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin3 - 3 Introductionw Sound financial decisions require adequate and accurate financial information. w 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, andsocial accounting data. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin3 - 4 Efficient Markets & Asymmetric Informationw 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. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin3 - 5 Efficient Markets & Asymmetric Informationw 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. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin3 - 6 Efficient Markets & Asymmetric Informationw In an efficient marketplace, each individual investor will rationally use all the relevant information that is available to value stocks and bonds. w Hence, each financial asset will generate an ordinary or normal rate of return commensurate with its level of risk. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin3 - 7 Efficient Markets & Asymmetric Informationw According to the capital asset pricing model (CAPM), the expected return on financial asset (or portfolio of assets) i, E(Ri), is:w 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 riski, asset is level of systematic risk 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin3 - 8 Efficient Markets & Asymmetric Informationw The line or curve described by the CAPM equation is usually called the security market line (SML).E(Ri)RMrF01.0market portfolio MSML 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin3 - 9 Efficient Markets & Asymmetric Informationw 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. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin3 - 10 Different Forms of the EMHw The weak form of the EMH argues that the current price of a financial asset already reflects all its price and trading volume history. w The semistrong form contends that the current price of a financial asset already reflects all publicly available and relevant information. w The strong form argues that the current price of a financial asset already captures all relevant public and private information. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin3 - 11 Different Forms of the EMHw Repeated research studies have essentially confirmed the weak and semistrong forms of the EMH. w 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. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin3 - 12Problems Informational Asymmetries Can CreatewLemons 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. 2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin3 - 13Problems Informational Asymmetries Can CreatewAdverse 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 (an