Finance Basics, part 1

There are many fundamental propositions in finance, but some are simply corollaries; that is, they follow directly from others. I will take as the fundamental that markets are in some sense “efficient” or “rational” and examine what this means for different areas of finance. We have to remember that most of finance revolves around financial markets and that these markets reflect the actions of many market participants – both buying and selling securities. In some sense it inevitably follows that market prices reflect the information of all of these participants in the market, so in a general sense these prices should be trusted. For example, one of the basic phrases in finance that summarize this idea is “Listen to the market.” Even if you don’t agree with it, market prices still provide information, and you should know what that information is.

Academics have developed a huge literature around the concept of market efficiency, which at its weakest assumes that all publicly available information is already reflected in security prices. Consequently, there is no value to buying shares based on past share price movements (momentum trading) or doing fundamental financial analysis using the firm’s financial statements. I’m not convinced that markets are as efficient with information as financial theory indicates for two reasons.

First, we have securities commissions, who constantly prosecute people for manipulation of security prices. If the markets were as efficient as some advocate, then it would not be possible to manipulate prices, so the mere existence of the SEC is a sobering reminder of potential market inefficiencies. Second, Enron and WorldCom have reminded us that financial statements can be misleading and that the auditors are not always to be trusted. The auditors are supposed to be the gatekeepers who make sure all material information is divulged to the markets. The “disappearance” of Arthur Andersen and the allegation that Andersen actively colluded to help Enron misstate their financial statements (by the use of special purpose vehicles) have heightened everyone’s awareness of the importance of transparency: All material information has to be divulged in a timely and informative manner.

However, the fact that the validity of market efficiency has been questioned should not blind us to its implications. In markets where all material information has been divulged and there is no inside information, market prices are more informative than in markets where the opposite is true. Consequently, I will first deal with four implications of market efficiency where the assumption that all available information is reflected in market prices is robust.

One obvious area where the capital market is likely to possess all available information is in the pricing of fixed income securities, particularly government securities. In most modern economies the central bank is legally as well as functionally separated from the government’s Treasury, that is, the branch that manages the government’s issue of securities. Consequently there is very little “inside information” as to where interest rates are likely to go. In fact, every statement of the Governor of the Federal Reserve System is scrutinized in detail to see whether there is some indication of what the Fed is likely to do. In the face of such intense scrutiny, it is difficult to believe anyone has inside information as to the path of future interest rates.