1. efficient capital market hypothesis a.

asset prices accurately reflect all available info relevant to projecting future cash flows b. prices set at level called for by asset pricing model by diversified investors c. asset prices will instantaneously adjust to new information i. not the real world but hypothesis says the world acts as if it si so d. asset prices adjust as quickly and accurately if everyone were rational and had all information 2. 3 forms of hypothesis (see handout) a. weak i. claims that since at least the info in old prices (which anyone can look at) is available, dont look at it its already been captured in todays prices 1. no more chances to make money 2. waste of time to study past prices ii. nothing to glean from old prices b. semi-strong i. says: not only do current asset prices reflect any info embodied in past prices, also reflects news that is out there in the public realm 1. already accounted for in prices 2. waste of time to try to study any info that is out there to outsmart the other guys.. a. if true, means you cant beat the market (w/o insider information) c. strong i. even if you have inside info, you cant beat the mkt its already out there 3. Evidence a. If its an efficient cap mkt, how expect assets to move over time? Do they move that way? b. If eff cap mkt, expect prices to move randomly w/ slight upward trend to reflect inflation

---------------Oct 12 1. Efficient Capital Markets Hypothesis (continued) a. 3 forms i. weak ii. semi-strong iii. strong b. evidence in support i. ...thinking of semi-strong form: 1. if all information is already impounded, then all new information affects prices a. so affect prices to move around randomly dont know what is coming i. so if prices jiggle around randomly, then that lends support to this idea ii. what if not efficient capital mkt? 1. if even pro money mngr cant beat the mkt consistently, then maybe no info gets reflected in prices fast enough for people to act iii. most investors will not accept that they are no better in terms of anyone else at outsmarting the other guy/beating the mkt c. psychological resistance i. very premise of hiring experts (eg money mngrs) is that those experts have more knowledge/expertise that helps them 1. therefore inclined to argue that its not an efficient cap mkt (bc otherwise theyd be useless) d. not saying that prices will be stable; nor is it saying that prices that come out of mkt accurately reflect fundamental value; i. merely saying reflects info that is out there whatever investors have/are thinking will be rapidly impounded in prices, such as: 1. herd mentality 2. optimism 3. pessimism ii. accordingly, instability and total departure of fundamental value are not critiques of the effic cap mkt hypoth; rather, a criticism of herd mentality of investors 2. what keeps a cap mkt efficient? a. People who think it is not efficient i. As long as there is a group of people looking for bargains, that will make the bargains disappear so people need to think there are no bargains for them to reappear b. Have to beat the herd to the bargains 3. If you get there, first you can make money a. What does it take to get there first?

i. Have to spend a lot of money gearing up to jump on opportunities before they disappear b. Gets expensive to beat everybody else i. Up to the point of where it would cost more to get there quicker 4. Implications for an ordinary investor a. Youre not going to beat goldman sachs to the bargains i. Prob buy and sell for prop price, but have to trade commissions to pay 1. Why not just stick with what you have? b. Investment strategy for ordinary investor: i. Put together diversified portfolio ii. Hold it. 1. Dont try to wheel and deal/day trade 2. Buy a low-fee fund and sit there 5. Gvt Intervention (regulation) a. Where productive? Where burdensome? b. Traditional merit regulation i. Really dont need c. Need anti-fraud regulation i. Making sure peoples exposures are honest ii. Crespi thinks should focus here, let the chips fall where they may elsewise d. Also prob dont need mandatory exposure regulation i. In an ECM and info is impounded in prices, dont really need to send [glossy brochures] to everybody 1. Could save a lot of money 6. Information Dissemination Mechanisms diff kinds of info gets accounted in diff places a. Universally Informed Trading: i. Certain info is out there and available to everyone ii. Alone is enough to generate weak-form efficiency 1. Its impounded in prices b. Professionally informed trading i. For semi-strong form efficiency: how does technical info that really only accountants and investors can read that is public in theory actually get disseminated in prices? 1. When firm releases quarterly info to SEC, it becomes available to the professionals/big traders who move mkts/influence prices a. Public info of limited access and is difficult to understand is available to the professionals/big traders c. Derivatively Informed Trade i. How is it that inside info gets transmitted into prices? How can you claim there is strong form efficiency? 3

1. Once it leaks, of course it is impounded 2. But before that, this theory says that before the insiders have told anybody else, it affects the price: a. Copy the people who look like they know something you dont know trade decoding ii. Price decoding see stock going up sig amounts 1. Jump on the bandwagon and buy it: figure it wouldnt be happening if something wasnt going on a. Eg announcement of merger 2. Looking for unexplained movements in pricing to anticipate what is out there iii. This is how insider info is reflected in prices. d. Uninformed Trading i. Weakest argument ii. Collective guesses random biases cancel out in a diversified investor community and culminates in a consensual pooling of limited info into a collective sense that is more substantial than any individuals 1. Crespi doesnt buy this what if were all too optimistic about real estate? a. Doesnt think independent perspectives cancel out i. In fact, believes it leads to more volatility 7. What to do w/ waves of optimism and pessimism? a. If you can figure out when that is going to happen, can make a lot of money before the bubble bursts or while prices are still dirt cheap i. Stay ahead of turnarounds in sentiment 1. In an ECM, prob think everyone is out there trying to do this 8. Directors of corps are agents on a longer leash: who is their principal? a. Have fiduciary duties but to whom? i. Loyal to corp? loyal to shareholders, aka residual claimants? Or both? b. Traditional common law position (not in statute but followed by almost all courts): i. Fiduciary duty runs only to corps common shareholders 1. Therefore highest duty of corp mngmt is to maximize present value of stream of cashflows to shareholders a. Not much analysis to this end in opinionsjudges embrace view w/o much reflection ii. Scholars tend to agree but for different reasons: 1. What is a fiduciary duty? Why impose duties beyond what kx agrees to? a. Kxs have gaps inconceivable to come up with a kx that covers every duty 4

2. Right way to fill gaps = hypothetical bargain principal: what would the parties have agreed to [at the moment of creation] had they taken the time to flesh it out? 3. One question that will ultimately come up is who mgmt. owes fiduciary duty to? a. Everyone will want it (employees, bondholders, shareholders, etc) b. But scholars say shareholders would come out with the fiduciary duty; if it didnt, nothing would come to them i. Employees can insist on salaries ii. All shareholders have is residual claim 1. Can insist on that whereas all other parties can insist on other things 2. So when push comes to shove, will agree that fiduciary duties will run to shareholders c. Smith (article): i. Agrees with (1) and (2) and that should fill with hypothetical bargain ii. Departure: thinks parties would not agree that fiduciary duties would run to the common shareholders 1. Would agree that FD runs to corp as a whole try to max overall profits as opposed to corporate revenues dedicated to shareholders a. Accordingly, cts should stop directing mgmt. to max revenues to shareholders but instead to entire corp d. See P. 381: 141(a) of DE corporate law statutes i. Leaves room for interpretation

------------------Oct 13 1. Review a. Fiduciary duties i. Cts: Should max value to shareholder ie of shares (increase stream of future cash flows and raise share price) 1. Smith article disagrees: should max total cashflow that goes to all common things a. Must understand his claims of who investors are vs. traditional view 2. Traditional view of investors (ie who contributes capital) a. 3 types of claimants i. Bondholders: lend money 1. Entitled to interest and repayment of principal ii. Common shareholders: residual claimants (leftover after bills) iii. Inbetween = preferred shareholders 1. Equity shs that get money after bhs and before c shs 2. Preferred stock? b. Implicit assumption that these are 3 separate groups of people, each with own interests i. Undiversified w/ few outside assets ii. Little if any overlap among them c. Directors/officers ultimately have to pick one group they are loyal to i. We think common shareholders 3. Smith a. Move fwd and look at how cap mkt actually operates b. Claimants i. Tend to be diversified investors 1. Typically either directly or indirectly (through mutual and pension, etc funds) invest in multiple entities and own lots of stuff lots of assets, diversified ii. Not 3 diff groups of people who just own parts of this corp but instead 1 group of people who tend to own a little of everything including some of this corp and parts of others 1. So what would they like? c. Imagine that investors are fully diversified (as opposed to somewhat) i. (Own a little piece of everything on the planet in proportion to the wealth of everything on the planet) ii. what kind of legal rules? 1. Example: a. Assets: i. $10 mill cash ii. $10 mill in assets b. liabilities: i. $15 mill in bonds c. owners _____: 6

d. e.

f.

g.

h.

i. $5 mill common shares 2. investment proj 1 vs investment 2: a. from shareholders perspective: i. p1, from pov of shareholders: get all gain or all loss ii. p2, from pov of shareholders: if bankrupt, bondholders take hit all they lose is equity 1. gambling with somebody elses money a. gamble, win? Win it all b. gamble, lose? Only lose half b. common shareholders ? Up 42% 3. bondholders pov: investment #2 virtually no upside and put at risk of losing all capital officers and investors of a leveraged firm are going to look at investments differently than the whole picture smith wants a set of legal rules that encourages corp officers to make sensible decisions that benefit everyone i. old regime is perverse and counterproductive (just thinking about shareholders hurts some more) 1. could create social risk 2. [and something else] a. if that is the case, very bad legal std to have cts have recognized this to some extent i. vicinity of insolvency doctrine: 1. where a corp has been so thinly capitalized that it is almost insolvent, then fid duty shifts from common shareholders to bondholders (bc they are really the ones at stake) wont succumb to shareholders to do the hail mary ii. but smith says go beyond: 1. not just a prob for very thinly capitalized cos w/ regard to certain debts, every corp (even wellcapitalized ones) when approached w/ certain risky investments can be w/in vicinity of insolvency who owns corps? investors own both common shares and common bonds i. they dont want you to maximize common wealth ii. they think like diversified investors 1. same people own various claims against co that could be injured max cash flow to everybody

i.

i. pick the investments that make that pie as big as possible bc investors own a little bit of everything instead of maximizing shareholder wealth where if at all is smith wrong? i. Not all corps are owned by diversified investors 1. Eg family corporations a. Banks own bonds b. May not own much else compared to their wealth 2. maybe need 2 rules ii. smith not thinking large enough 1. if want to max effect on everyone, why not include employees?