Financial Markets and Economic Efficiency

Hello Friends!

We will now begin with discussion of the relationship between financial markets and economic efficiency. Financial markets facilitate mutually beneficial intertemporal exchanges by organizing trading in financial securities. These securities, and the information contained in their prices, enable individuals to reach higher levels of lifetime utility than would be possible in the absence of financial markets. We begin this chapter with a brief treatment of financial securities, followed by a discussion of the more important tasks that financial markets must perform to be economically efficient. We include brief treatments of two kinds of market failures. We conclude with a general discussion of informational efficiency and the efficient markets hypothesis.

2.1 Financial Securities

A financial security is a saleable right to receive a sequence of future payments. The size of each future payment can be either guaranteed or determined by the outcome of some uncertain future event. The number of payments in the sequence can be finite, or the sequence can continue indefinitely into the future. Here are five examples, presented in order of increasing complexity:

Definition of a Bond

“A bond is a saleable right to receive a finite sequence of guaranteed payments.”

For example, a bond could be a saleable right to receive $100 on the last business day of March, June, September, and December, beginning in March 2002 and ending in December 2010, plus a single payment of $10,000 on the last business day in 2010. This bond would be analogous to a bank account from which a person intends to withdraw $100 each calendar quarter during the years 2002 through 2010, with a final withdrawal of $10,000 at the end of 2010 that will reduce the balance in the account to zero.

That the bond is saleable means that an investor who purchases the bond when the firm issues it early in 2002 does not have to hold the bond until 2010, when the firm makes the final payment required by the bond. In other words, any time before the end of 2010, the investor can sell the bond to another investor. The second investor purchases from the first investor the right to receive the payments that remain in the sequence. Of course, the price that the second investor will pay depends on how many payments remain in the sequence, and on the second investor’s alternative opportunities for investment. The fact that the bond is saleable to other investors makes it more attractive to any investor.

A bond is a contract between a borrower and a lender. The borrower could be a single person or a firm. Similarly, the lender could be a single person or a financial institution such as a bank, an insurance company, or a pension fund. The borrower is the issuer of the bond; the lender is the owner of the bond. The contract that defines the bond requires the issuer of the bond to make a specified sequence of payments to the owner of the bond, and to do things that protect the bond’s owner against the possibility that the issuer might not make the promised payments on time. Typically, the borrower issues the bond to obtain funds to finance the purchase of an asset as an investment. For example, a railroad might issue a bond to purchase a set of new locomotives. To protect the interests of the lender, the borrower might be required to maintain insurance on the locomotives, and to allow only engineers certified by the Federal Railroad Administration to operate those locomotives.

By the definition of a bond, the obligations of the issuer of the bond to whoever owns the bond at the moment are guaranteed. But what is the nature of the guarantee?

What recourse is available to the owner of the bond should the issuer fail to meet his or her obligations, for example, by failing to make the promised payments on time, or by failing to carry the required amount of insurance?

The legal term for a failure to meet one’s contractual obligations specified by a bond is default.

If the issuer creates a default, the present owner of the bond acquires specified rights to the assets of the issuer. For example, should a railroad fail to make the required payments to the owner of the bond, that owner might acquire the right to ask a court to seize the locomotives, sell them, and use the proceeds to make the required payments to the owner of the bond.

The saleability of bonds enables investors to create mutually beneficial exchanges. Consider the following example of a bond issued by a person to finance the purchase of a house.

Homeowners frequently finance the purchase of a home by borrowing money from a bank. To induce the bank to make the loan, the homeowner issues a bond to the bank. The bond requires the issuer (the homeowner) to make a specified sequence of payments to the owner of the bond (the bank) and to do various things to protect the bank’s interest, such as carrying fire insurance, paying the property taxes, and maintaining the home in good repair. The homeowner guarantees performance of these obligations by giving a mortgage to the bank. The mortgage is a lien on the property that entitles the bank to seize the property and sell it should the homeowner create a default.

Banks that purchase bonds issued by homeowners usually sell those bonds to other investors, who form a pool of these bonds. These investors then issue securities that are saleable rights to the sequences of payments that the homeowners have promised to make. These securities are called mortgage-backed securities. Although the homeowners will make the payments directly to the banks that originated the loans, the banks will pass those payments to the investors who purchased the mortgaged loans, and those investors will, in turn, pass the payments to the persons who purchased the mortgage-backed securities. This process of creating mortgaged-backed securities is an example of a set of mutually beneficial exchanges. The banks specialize in originating loans, rather than purchasing rights to receive sequences of payments.

The investors who purchase the loans from the banks specialize in creating diversified pools of loans, and thus reducing the risks borne by the persons who purchase the securities that are backed by this pool of loans.

The issuer of the bond borrows money by selling the bond to an investor, who thereby becomes a lender. The price that the investor will pay for the bond determines the cost that the investor pays for obtaining the loan.

Definition of Common Stock

“A share of common stock is a saleable right to receive an indefinitely long sequence of future payments, with the size of each payment contingent on both the firm’s future earnings and on the firm’s future opportunities to finance new investment projects. These payments to the stockholders are called dividends.”

Typically, a firm will pay a dividend on its common stock at regular intervals, such as semiannually or quarterly. Shortly before each date on which a dividend is scheduled, the firm’s directors announce the size of the forthcoming dividend. The directors are free to choose whatever size of dividend they believe is in the longer term interests of the investors who own the common stock.5 The directors might retain some of the firm’s earnings for use in financing future investment projects. In particular, the directors can decide to pay no dividend.

Unlike a bond, a share of common stock is not a contractual right to receive a sequence of payments. The owners of the common stock are the owners of the firm.

As owners, the (common) 6 shareholders elect persons to the board of directors and thereby control the firm. The directors determine the size and the timing of the dividend payments. In particular, the directors can use some or all of the firm’s earnings to finance new projects, rather than paying those earnings to the shareholders as dividends.

Payments to bondholders and shareholders depend on the firm’s ability to generate earnings. As explained above, the bondholders have a contractual claim on those earnings. By contrast, the shareholders have a residual claim on the earnings. The directors may pay to the shareholders whatever earnings remain after the bondholders are paid, although the directors may retain some or all of those residual earnings to finance new projects.

Firms issue common stock to raise money to finance projects. Unlike the case of a bond, the investors who purchase newly issued shares of common stock from a firm do not have the right to get their money back at the end of some specified number of periods. These investors can, however, in effect withdraw their money by selling their shares to other investors, just as investors who own bonds can withdraw their money prematurely by selling bonds to another investor. Of course, the ability of an investor to withdraw money by selling a security depends on the current price of that security.

That current price depends on all investors’ current expectations of the ability of the firm to generate earnings over the future.

If common stocks were not saleable rights, firms would have difficulty financing new projects by selling common stock. To understand the economic significance of the saleability of rights, consider the decision to construct a new home. A house provides a stream of services over time. These services occur as protection from the elements, a commodious place in which to raise a family and to enjoy one’s friends and relatives, and a safe place to store important possessions. It is difficult to construct a home that is both comfortable and that will not outlast the time when the owner either wants to move elsewhere (e.g., for retirement) or dies. Few persons would construct a comfortable home designed to last many decades if they did not have the right to sell or to rent that home to another person at any time in the future. The right to sell the home provides people who finance the construction with the ability to “disinvest” should they want to reallocate their resources in the future. It would be economically inefficient to prohibit transfers of ownership of existing homes. If such a prohibition were in effect, there would be far fewer homes built, and those that were built would be less comfortable and less durable. Moreover, the incentive to preserve the homes through timely maintenance would be diminished.

The same arguments apply to expensive and durable capital goods, such as a railway line. The investors who finance the construction of the line by purchasing securities from the railroad acquire a right to receive dividends based on the future earnings generated by the line. But few persons would purchase the new securities without the right to disinvest in the future by selling the securities to other investors.

Definition of a Callable Bond

“A callable bond is a bond that the issuing firm has the right to cancel by paying to the bond’s current owner a fixed price that is specified in the definition of that bond.”

A firm might want to issue a callable bond to provide a quick way to refinance its debt should interest rates fall. Of course, the same callability that provides an advantage to the firm that issued the bond creates a disadvantage to an investor who holds that bond. Should the firm call the bond when interest rates fall, the owner of the bond will receive cash? With interests now lower, the former owner of the bond will have to accept a lower rate of return when he or she reinvests that cash. Therefore, to induce investors to hold callable bonds, the issuing firms will usually have to provide some incentive, such as setting the levels of the promised payments higher than they would be on a bond that is identical in all other respects, but that is not callable.

Definition of a Convertible Bond

“A convertible bond is a bond that provides its owner an option to convert the bond into a fixed number of shares of the firm’s common stock at a fixed price. The firm that issued the bond must accept the conversion by either issuing new stock to the converting bondholder, or by purchasing shares of its own stock in the market and delivering them to the converting bondholder.”

Sometimes a firm lacks sufficient funds to finance a profitable investment project. In many of these cases, it is possible to construct a mutually beneficial exchange between the firm’s current shareholders and new investors who could finance the project by purchasing new securities issued by the firm. The problem is that the prospective new investors fear that the firm’s managers will use their superior information to offer the new securities only under conditions that will transfer wealth from the new investors to the current shareholders. That is, while the new project offers a potential for a mutually beneficial exchange, the possibility that the managers might exploit their superior information to the detriment of the new investors prevents the old shareholders and the new investors from realizing this potential for mutual gain. By definition, this inability to realize a potential for a mutually beneficial exchange is an example of economic inefficiency.

Under some conditions, current shareholders and new investors can eliminate the inefficiency created by the managers’ superior information by selling bonds that are both callable and convertible. One of the required conditions is that, to protect themselves against losing wealth to the firm’s current shareholders, the prospective new investors will finance the project only by purchasing bonds rather than purchasing newly issued shares of stock. Bondholders have more protection in the event that the proposed project fails to generate the levels of earnings anticipated by the firm’s managers.

A second condition is that the managers of the firm must incur sufficiently large costs to their reputations as managers if the firm were to default on the bonds. Most investment projects have some probability of failing to generate sufficient earnings to enable the firm to make the promised payments on the bonds. If the firm has no bonds outstanding, there can be no default, because there are no contractual claims.

Therefore, for any given probability of default, the higher the reputational cost to the managers of a default, the stronger is their incentive to induce the bondholders to convert their contractual claims (the bonds) to residual claims (shares of stock). If the price at which the firm can call the bonds is sufficiently low, and if the proportion of the ownership of the firm that the converting bondholders can acquire by converting their bonds to stock is sufficiently high, the managers can induce the bondholders to convert once the project gets underway and begins to show promise, but no guarantee, that there will be no default.

In summary, when managers have superior information about a potentially profitable new project, prospective investors might be willing to finance the project only by purchasing bonds. Managers, however, because of concern about the damage to their reputations, might be willing to have the firm finance the project only by selling newly created shares of stock. Neither bonds nor stock will enable the potential new investors and the firm’s current shareholders to effect a mutually beneficial exchange.

Under some conditions, issuing a callable, convertible bond, which is a hybrid of a bond and common stock, will enable the firm to effect the mutually beneficial exchange that would otherwise be foregone.

The last example of a financial security that we offer here is a call option.

Definition of a Call Option

“A call option is the right, but not the obligation, to purchase a specific security at a fixed price by paying an exercise price prior to a fixed date.”

2.2 Transaction Costs

An important way in which financial markets assist individuals in making intertemporal exchanges is to reduce transaction costs. The term transaction costs is broadly defined to include all those costs that individuals incur to make exchanges. Two individuals can make a mutually beneficial exchange only if they have different preferences (such as willingness to tolerate uncertainty). But these individuals must first find each other, and then they must agree on the terms of the exchange. As stated earlier, these terms can be quite complex if the exchange is an intertemporal one.

Consider, for example, the complexity of the terms in a callable, convertible bond. Financial markets reduce these costs by providing easy access to a central location at which individuals can trade standardized securities. Financial securities are usually traded on exchanges. Common stocks, for example, are traded on the New York Stock Exchange, the American Stock Exchange, and on an informal but highly integrated organization of dealers called the over-the-counter market. Bonds are traded through a set of independent and competing dealers. This informal network of dealers is known as the over-the-counter exchange. Options are traded on many organized exchanges, including the American Stock Exchange, the Boston Options Exchange, and the Chicago Board Options Exchange.

Some securities require one or both parties to an exchange to purchase or sell some other security, or some commodity, on a future date. Associated with the exchanges on which these securities are traded are clearinghouses which guarantee that the investors who trade in these securities will meet their obligations. By insuring individual investors against the risk of default by other investors, the clearinghouses increase the attractiveness of these securities as the basis for mutually beneficial exchanges.

2.3 Liquidity

The liquidity of an asset is a measure of the increase in the cost that one would incur as a consequence of increasing either the size of a transaction in that asset or the speed at which the investor wants to conclude the transaction. A highly liquid asset is one for which the price at which the asset can be bought or sold is little affected by increases in the speed or the size of the transaction. Some examples will help.

2.4 The Problem of Asymmetric Information

There is an asymmetry of information in a proposed exchange if one of the persons has better information than the other person about the likely outcome of the exchange. If the person with the superior information could credibly reveal the information to the other person, the two persons could create a mutually beneficial exchange. But if the person with the superior information cannot credibly reveal that information, a potential mutually beneficial exchange will be foregone and, therefore, there will be an inefficient allocation of resources. This inefficiency arises not because the outcome of the proposed exchange is uncertain. It is relatively easy for two persons to create a mutually beneficial exchange that involves claims to an uncertain outcome if both parties to the exchange are equally informed about the probabilities of the possible outcomes. Rather, it is the asymmetry of information that can prevent what, under symmetric information, would have been a mutually beneficial exchange.

Asymmetric information is a significant problem for firms. The managers of a firm will often have superior information relative to investors about the uncertain outcomes of a proposed investment project. If the firm does not have sufficient internal funds to finance the project, the managers will have to raise funds externally by offering new securities to investors. Asymmetric information between the managers and the prospective new investors may prevent the managers from raising funds on terms that will prevent a transfer of wealth from the firm’s current shareholders to the new investors. Consequently, the firm will choose to forego an investment project that could increase the wealth of both the current shareholders and the new investors.

Therefore, there will be an inefficient allocation of resources.

The seminal contribution to the problem of asymmetric information is the paper by George Akerlof titled “The Market for ‘Lemons’: Quality, Uncertainty, and the Market Mechanism.”12 In 2001, Akerlof was awarded a Nobel Prize in economics for his work on asymmetric information. Akerlof’s work has generated a large literature.

He analyses a market for used automobiles to show how asymmetric information between buyers and sellers can cause the market to collapse, with the result that opportunities for mutually beneficial exchanges are foregone; as a result of this collapse, the market fails.

2.4.1 George Akerlof’s Lemons Model

In the simplest version of Akerlof’s model, used automobiles vary in quality. For our purposes, we will measure the quality of an automobile as the number of miles of transportation that it will produce per $100 of expenditures for maintenance and repair. Suppose that the qualities of the automobiles are uniformly distributed over the interval from 0 to 100. An automobile that will provide 10 miles of travel for each $100 of expenditure will have a quality rating equal to 10. An automobile that will provide 70 miles of travel for each $100 of expenditure will have a quality rating equal to 70. The worst automobile will thus have a rating equal to 0; the best will have a rating equal to 100. Since the automobiles are uniformly distributed by quality ratings over the interval from 0 to 100, exactly half of the automobiles have ratings between 0 and 50. Similarly, 20% of the automobiles lie within the interval between 70 and 90, and so forth.

Now suppose that each seller of an automobile knows the quality rating of the automobile that he or she offers for sale. Buyers, on the other hand, know only that the automobiles are uniformly distributed by quality ratings over the interval from 0 to 100. This lack of inside knowledge enables a buyer to determine only the probability that a particular automobile will have a quality rating that lies within a certain interval; beyond that, the buyer faces uncertainty. For example, a buyer will know that there is a 30% probability that a particular automobile will have a quality rating between 60 and 90. With the same 30% probability, the quality rating of that automobile will lie between 40 and 70.

What price should a buyer offer for an automobile? Under reasonable assumptions about attitudes toward risk, we would expect a rational buyer to offer a price that is compatible with the average quality of the automobiles that are for sale. For example, suppose that the buyer is a taxicab company that purchases large numbers of used automobiles each year. If the quality ratings of the used automobiles offered for sale are uniformly distributed from 0 to 100, this company can expect that the average quality of the automobiles that it purchases each year will be equal to 50. Therefore, the price that the company will offer for any particular automobile will be based on the assumption that the quality of that automobile will be equal to 50. Now consider the sellers of these used automobiles. Each seller knows the quality rating of each of his automobiles. Suppose that Mr. Black knows that the quality rating of his automobile is 75. Unless he can certify this quality to prospective buyers, he will have to accept a price based on a quality rating of only 50. The alternative is to withdraw his offer to sell the automobile. The same situation faces half of the prospective sellers, who know that the quality ratings of their automobiles exceed 50. In Akerlof’s model, half of the prospective sellers will therefore withdraw from the market because they know that the market will underprice their automobiles. Consequently, the automobiles offered for sale have quality ratings that range from 0 to only 50. Although the prospective buyers cannot determine the quality of any particular automobile, they do know the distribution of quality ratings. Therefore, the buyers can anticipate that the average quality rating of the automobiles offered for sale will be equal to 25, not 50.

Buyers will then revise the price that they are willing to pay downward to a value that is compatible with a quality rating of 25. This downward revision of the buyers’ prices will cause the sellers to withdraw those automobiles that have quality ratings between 25 and 50, and the price that buyers will offer will decrease further. This process is degenerative. In the limit, the market collapses because no seller can expect to obtain a fair price for an automobile.

In Akerlof’s model, the market fails because there are potential mutually beneficial exchanges that are not realized. The failure of the market occurs because there is asymmetric information between buyers and sellers, and the sellers have no way to transmit their information credibly to the buyers.

Consider again Mr. Black, whose automobile has a quality rating of 75. Suppose that Mr. Black has a strong preference for new automobiles. Specifically, he is willing to sell his current automobile for a price that would be appropriate for a quality rating of 65, so that he could apply the proceeds of that sale toward the purchase of a new automobile. Ms. Green, on the other hand, would be willing to pay more than what Mr. Black is willing to accept if she can be certain that the quality rating of his automobile is 75. If Mr. Black could credibly transmit his information to Ms. Green, they could conclude a mutually beneficial exchange. But in the absence of a way to eliminate the asymmetry of the information, the potential for mutual gain will be foregone, and thus the market will fail. Only by eliminating the effects of the asymmetric information will the market be able to promote an efficient allocation of resources.

2.4.2 A Simple Example of Asymmetric Information and Economic Inefficiency for a Firm

We present a simple example of how asymmetric information between a firm and prospective new investors can create an inefficient allocation of resources. Assume first that the only kind of security that a firm can issue is common stock. Firms have prospective profitable projects but lack sufficient internal funds with which to finance them. Being profitable,14 the new projects could provide a mutually beneficial exchange between new investors, who would finance the projects by purchasing newly created shares of common stock, and the firms’ current shareholders. Before the firm sells newly created shares, the current shareholders own 100% of the firm.

By purchasing newly created shares, the new investors provide additional resources to the firm. In exchange, the new investors acquire a portion of the ownership of the firm from the current shareholders. Whether the new investors gain or lose wealth depends on (1) the value of the resources that the new investors transfer to the firm by purchasing the new shares, (2) the amount by which the value of the firm will increase once the new project is undertaken, and (3) the proportion of the ownership of the firm transferred from the current shareholders to the new investors. The prospective new investors have reason to fear that firms will exploit their superior information so that the combined effect of factors (1), (2), and (3) will transfer wealth from the new investors to the current shareholders, thus imposing a net loss on the new investors.

Consequently, the prospective new investors will not purchase the new shares, the firms cannot undertake the projects, and the profit that could have been shared by the new investors and the current shareholders is foregone. Since potential mutually beneficial exchanges are foregone, resources are allocated inefficiently; there is a deadweight loss.

Consider another example. There is a large number of firms in the economy, half of which are strong firms and half of which are weak firms. Each firm will survive for exactly one more year, after which it will be rendered worthless. During that final year, each strong firm will generate earnings equal to $150 from its regular operations.

Each weak firm will generate only $50 from its regular operations.

Each strong firm and each weak firm has an opportunity to invest in a new project that will increase that firm’s earnings for its final year. The cost of the new project is $100 for each firm. A strong firm can use the new project to increase its earnings by $120. A weak firm can generate only $110 in additional earnings from the project. The management of each firm knows whether that firm is strong or weak. No one else can discover whether a particular firm is strong or weak until the end of the final year. Assume that the bank’s interest rate is zero.15 Since the project costs only $100, every firm has an incentive to undertake the project. Alas, each firm has paid out in dividends to its shareholders all of its earnings from previous years; consequently, no firm has any idle cash with which to finance new projects.

Because no firm has idle cash, a firm must sell new shares of stock to raise the $100 required to start the project. If a firm sells new shares and undertakes the project, two things will occur. First, the value of the firm will increase because the project is profitable. Second, once the new shares are issued, the proportion of the firm owned by the current shareholders will decrease by the proportion of the firm that the new shareholders acquire. The new shareholders will own a proportion of the entire firm, including the new project. Their claim is not limited to the earnings of that project. If the proportion of the firm acquired by the new shareholders is too large relative to the value of the new project, the current shareholders will lose wealth as a consequence of financing the project by issuing new shares.

We will now show that with the numerical values in the present example, current shareholders in a strong firm will forego the new project even though it is profitable.

If an allocation of resources leaves a profitable project lying idle, that allocation is economically inefficient. There is at least one alternative allocation that would increase the wealth of some persons without decreasing the wealth of any person.

Due to the asymmetry of the information, the new investors will regard any firm that tries to finance a new project as if that firm were an average of a strong firm and a weak firm. Therefore, the proportion of the firm that the new investors will insist on acquiring will exceed the proportion that they would accept if they could be certain that the firm is a strong firm. The current shareholders in a strong firm will forego the new project because the proportion of the firm that they would have to cede to new investors (to induce them to finance the project) is so large that the new investors’ claim on the firm’s earnings would exceed the earnings of the new project.

The first step in demonstrating this result is to determine the total market value of a firm’s shares. We will proceed by considering three alternate situations: in the first situation, no firm invests in the new project; in the second situation, each firm undertakes the new project and finances it by issuing bonds; and in the third situation, each firm attempts to finance the project by selling new shares. In all three situations, only the managers of each firm know whether that firm is strong or weak.

Consider the situation in which no firm undertakes the project. In this case, no firm will issue any new securities because there is no reason to raise additional financing.

2.5 The Problem of Agency

In the preceding section on asymmetric information, the market failed to realize some mutually beneficial exchanges because of an inability of some persons to transmit information credibly to other persons. If the firm’s investors and its managers were the same persons, this asymmetry would not arise. In this section, we briefly consider a second problem that arises from the separation of investors and managers. This is the problem of agency.

Agency is a relationship between two persons, or groups of persons. One person, called the principal, provides the resources for an enterprise and employs a second person, called the agent, to operate the enterprise. The principal not only determines broad policies for the agent to follow but also allows the agent some flexibility in administering these policies. The problem of agency is that the agent might exploit the flexibility provided by the principal by administering the enterprise so as to favor his or her own interests rather than those of the principal.

For example, a principal purchases a motel and employs an agent to manage it. In addition to renting rooms and collecting revenue, the agent is obligated to find economical ways to purchase supplies and supervise the staff so as to maintain the reputation of the motel as clean, safe, and friendly. The principal allows the agent to illuminate the No Vacancy sign at a “reasonable” time. The principal pays the agent a fixed salary that does not depend on the motel’s occupancy rate.

The agent has a conflict of interest with the principal. It is clearly unreasonable for the principal to expect the agent to remain awake every night until the last room is rented and then work regular hours the next day. Indeed, on some nights the motel will remain below full occupancy throughout the night. On the other hand, few principals would be satisfied to have the No Vacancy sign illuminated at 5:00 P.M. every day, regardless of how many rooms remain vacant. What will the agent do? What should the principal expect the agent to do? The agent’s behavior will surely affect the principal’s return on investment. It is naive to expect that the agent will resolve in the principal’s favor every instance in which there is a conflict of interest. This fact will make any potential rate of return from the motel less attractive. If the problem of agency is sufficiently severe, the principal will not invest, with the possibility that some mutually beneficial exchanges will not be realized.

Consider a second example. In this example, the interests of a firm’s managers will cause them to diversify the firm’s investments across projects to an extent that is not compatible with the interests of the firm’s shareholders.

Most investors diversify their holdings over several firms’ securities. By doing so, investors can reduce the amplitude of the unpredictable variability of the rate of return on their invested funds, without reducing the average rate of return on those funds. This is possible because it is highly unlikely that every firm’s earnings will increase by the same percentage or decrease by the same percentage in the same year. Afirm’s earnings are subject to two kinds of unpredictable forces. One kind of force affects single firms or single industries, without affecting the entire economy. An example of this would be a shift of consumers’ preferences away from dining and entertainment outside of the home, in favor of spending more time in the home. The other kind of force affects all firms in the economy, but not to the same degree. An example of this would be a decision of the Federal Reserve Board to change interest rates.

Most large firms operate several investment projects simultaneously. Portfolio theory, which we present in chapter 8, indicates that these firms face a trade-off between the average rate of return on their capital and the variability of that rate of return. To a limited extent, a firm can decrease the variability of its rate of return, without decreasing its average rate of return, by choosing projects whose individual rates of return are not highly correlated with each other. But once the firm has chosen projects that will minimize the variability of its rate of return while producing a given average rate of return, any further decrease in variability requires that the firm accept a reduction in its average rate of return.

The firm’s shareholders and its managers have a conflict of interest with regard to choosing the combination of the firm’s average rate of return and the volatility of that rate of return. Managers’ wealth consists of a portfolio of financial securities and the market value of their reputation as managers. The financial securities can generate income, either now or when the managers retire. Their reputations will affect their ability to secure another managerial position should they lose their current position or desire to move elsewhere. The greater the volatility of the firm’s rate of return, the greater the risk that a manager could lose his or her position. Therefore, the greater the importance of the manager’s reputation as a component of her wealth, the stronger the incentive to choose investment projects that will reduce the volatility of the firm’s rate of return, even if this will reduce the firm’s average rate of return.

For example, suppose the firm has debt in its capital structure. Debt requires that the firm make periodic payments of interest, regardless of whether the firm’s earnings at the time that the interest payments are due are high or low. The greater the volatility of the firm’s earnings, the greater the risk that the firm will have trouble making the interest payments. If the firm encounters this kind of difficulty, the manager’s reputation might suffer.

Atypical shareholder will not have his or her wealth as heavily concentrated in the firm as the firm’s managers do, because reputation is not an issue for the shareholder.

The shareholder will create an investment portfolio by purchasing the securities of several firms, just as a single firm will operate a portfolio of investment projects.

Therefore, the shareholder is in a situation that is analogous, but not identical, to the situation of a single firm. Within limits, the firm can reduce the volatility of its rate of return by diversifying its investments across projects whose rates of return are not highly correlated. Similarly, shareholders can reduce the volatility of the rate of return on their portfolios by diversifying their investments across firms whose rates of return are not highly correlated. Both the firm and the shareholder can reduce the volatilities of their rates of return by accepting a decrease in their average rates of return.

Shareholders, however, enjoy a more favorable trade-off between the average rate of return and the volatility of the rate of return than does the firm. By making investments in several firms, shareholders can diversify their portfolios across the aggregate of all the projects undertaken by all of the firms. Since shareholders can diversify over a larger set of projects than any one firm can, they can reduce the volatility of their rate of return while incurring a smaller sacrifice in the average rate of return than a single firm can.

Since managers have a higher concentration of wealth, including their reputation, invested in the firm than the typical shareholders do, managers have a stronger incentive to reduce the volatility of the firm’s rate of return than its shareholders do.

Therefore, managers and shareholders will often have different preferences about the projects in which the firm should invest.

2.6 Financial Markets and Informational Efficiency

2.6.1 Information and Mutually Beneficial Exchanges

We have seen that the economic function of financial markets is to facilitate mutually beneficial intertemporal exchanges. One element of this function is to reduce the costs of learning about opportunities to make these exchanges. Financial markets reduce these costs by creating a set of equilibrium prices for an extensive variety of financial securities.

We know that a financial security is a saleable right to receive a sequence of payments.

These sequences of payments are the results of intertemporal exchanges. Since the exchanges are intertemporal, the payments necessarily involve both waiting and risk. In equilibrium, the relative prices of these securities enable investors to evaluate the underlying intertemporal exchanges on the basis of waiting and risk. By extension, individuals can use the prices of existing financial securities to identify opportunities for new mutually beneficial exchanges.

In later chapters, we explain how individuals can use the relative prices of existing securities to identify prospects for new exchanges. For now, however, we will address the economic efficiency and the informational content of the prices of financial securities.

Any system of markets can be evaluated by its contribution to economic efficiency.

We recall that economic efficiency is an allocation of resources in which there are no further opportunities for mutually beneficial exchanges. Financial markets contribute to economic efficiency by creating a set of relative prices for financial securities that contain information about mutually beneficial intertemporal exchanges. If financial markets are to be economically efficient, then the information about the potential costs and benefits in prospective intertemporal exchanges that is contained in the prices of financial securities must be comprehensive and accurate. That is to say, the information must be such that there are no potential beneficial exchanges that are foregone. We say that financial markets are informationally efficient if the information contained in the prices of securities is comprehensive and accurate in the sense just described.

2.6.2 The Efficient Markets Hypothesis

Definition of the Efficient Markets Hypothesis

“The efficient markets hypothesis states that the current price of each financial security accurately reflects all the information that is known today about the sequence of future payments that will accrue to an investor who owns that security.”

The information includes the distribution of those payments over time, and the amplitude of their unpredictable variability. If the efficient markets hypothesis is true, then each security will be priced so that its expected rate of return will provide an investor who holds that security with the equilibrium levels of compensation for waiting and for bearing risk. There will be no mispriced securities. Consequently, if the efficient markets hypothesis holds, it will be impossible for an investor to find a security whose rate of return will, on average, outperform the market after allowing for waiting and for bearing risk.

2.6.3 The Joint Hypothesis

The efficient markets hypothesis states that the current prices of financial securities are such that the expected rate of return on each security will provide the equilibrium level of compensation for the waiting and the risk that an investor who holds that security must bear. This means that any empirical test of the efficient markets hypothesis is conditional on a second hypothesis that specifies the equilibrium relationship among expected rates of return, waiting, and levels of risk. Further, this second hypothesis must specify how we are to quantify these risks.

There are several alternative models of equilibrium in financial markets. The seminal model is the capital asset pricing model, which we will study in chapter 9. In this model, the quantity of risk in a security is measured by the correlation between its rate of return and the rate of return on a special portfolio that contains all the securities in the market. But the capital asset pricing model is only one of several alternatives that economists have studied as descriptions of equilibrium in financial markets.

The empirical test of the efficient markets hypothesis depends on whether security prices reflect information with sufficient accuracy so that investors cannot, on average, outperform the market by finding securities that will provide rates of return exceeding the equilibrium levels of compensation for waiting and for bearing risk. But the measurement of these equilibrium levels of compensation is conditional on the model of equilibrium that the economist chooses. Therefore, the efficient markets hypothesis is one part of a joint hypothesis. If investors could outperform the market by using a particular strategy, there are always two competing explanations between which the economist cannot distinguish. One explanation is that the efficient markets hypothesis does not hold; there is information about future earnings that is not accurately reflected in current prices. That is, investors can find securities that are mispriced.

The competing explanation would be that the economist is using the wrong model to define the equilibrium relationship among expected rates of return, waiting, and risk.16We shall encounter the joint hypothesis throughout the later chapters in this book when we consider empirical studies of financial markets.