Question

Own words: discuss it market efficiency in responding to potential earnings management.

Answer 1

Discuss market efficiency in responding to potential earnings management?

• The term market efficiency is used to explain the relationship between information and share prices in the capital market.
• Earlier EMH was known as Random Walk Theory
• Stock prices fully reflect all available information instantaneously and accurately.
• Price of a share approximates to intrinsic value, no under or overvalued shares
• Share price movements represent a random walk than an orderly movement.
• Different forms of market efficiency are:

1. Weak Form

• The theory that security prices reflect all market data, referring to all past price and volume trading information.
• Weak form of EMH is popularly known as Random Walk Hypothesis. This is a direct repudiation of technical Analysis.
• Implication:

• If Weak Form efficient, historical trading data will already be reflected (discounted) in current prices and should be of no value in predicting future price changes.

1. Semi-Strong Form

• Security prices reflect all publicly available information.
• Publicly available information includes: Historical price and volume information; Published accounting statements and annual reports
• Assumes the weak-form set of information as well as all public information pertinent to the security such as: Earnings; Dividends; Corporate investments; Management changes
• Implication:

• If semi-strong efficient, it is futile to analyse public information such as earnings projections and financial statements in an attempt to identify underpriced or overpriced securities.

1. Strong Form

• The theory that stock prices fully reflect all information, which includes both public and private information.
• Implications:

• Stock prices are fairly priced.
• It is not possible to use public information to identify over-priced or underpriced stocks
• It is not possible to use insider information to identify over-priced or underpriced stocks