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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 by the
borrowers, lenders and policy makers
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
3-5
The Great Debate Over
Efficient Markets & Asymmetric Information
The other view is asymmetric information
argues that the financial marketplace
contains
Pockets of inefficiency in information
availability
Pockets of inefficiency in use of information
3-6
The Great Debate Over
Efficient Markets & Asymmetric Information
3-7
The Great Debate Over
Efficient Markets & Asymmetric Information
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 3-12
Insider Trading Counterargument
3-13
Insider Trading Enforcement
3-15
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
3-16
Problems Asymmetries Can Create
3-17
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 3-18
Problems Informational
Asymmetries Can Create
Adverse selection
Asymmetric information before a contract
completed
One party only chooses contracts that will
benefit self
3-19
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
3-20
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
3-21
Asymmetry, Efficiency, &
Real-World Markets
All real-world markets have elements of
both efficiency and asymmetry
3-22
Informational Asymmetries
and the Law
3-23
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
3-24
Behavioral and Experimental
3-26
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
3-27
Sources of Information
Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, selected issues
3-29
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)
3-30
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. Moodys, S&P, Dun & Bradstreet),
directories & databases, journals &
magazines, credit bureaus
3-31
Sources of Information
3-32
Sources of Information
3-33
Markets on the Net
American Economic Association at
http://www.aeaweb.org
Answers.com at answers.com/topic/random-walk-
hypothesis
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
3-34
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
3-35
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
Moodys 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
3-36
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
3-37
Markets on the Net
3-38
Chapter Review
3-41
Appendix
Social Accounting
3-42
Social Accounting Data
3-43
National Income and Product Accounts
3-44
National Income and Product Accounts
The Components of the U.S. GDP, 2006 ($ billions, current)
Source: U.S. Dept of Commerce and the Federal Reserves Flow of Funds Accounts
3-45
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
3-46
Flow of Funds Accounts
3-47
Financial Assets and Liabilities
for the Household Sector
Source: The Federal Reserves Flow of Funds Accounts. ($ Billions) *Annualized data from Q1. 3-49
Total Net Borrowing and Lending
in Credit Markets
Source: The Federal Reserves Flow of Funds Accounts. ($ Billions) **Annualized data from Q1.
3-50
Funds Raised in
Credit and Equity Markets
Source: The Federal Reserves Flow of Funds Accounts. ($ Billions) *Annualized data from Q1. 3-51
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
3-52