Firms and Financial Markets

The information that firms convey to financial markets is often erroneous, and sometimes misleading. The market price that emerges from financial markets can be wrong, partly because of inefficiencies in markets and partly because of the errors in the information. There are no easy or quick fix solutions to these problems. In the long term, however, there are actions that will improve information quality and reduce deviations between price and value.

Improving the Quality of Information

While regulatory bodies like the Securities and Exchange Commission can require firms to reveal more information and penalize firms that provide misleading and fraudulent information, the quality of information cannot be improved with information disclosure laws alone. In particular, firms will always have a vested interest in when and what information they reveal to markets. To provide balance, therefore, an active market for information, where analysts, who are not hired and fired by the firms that they follow, collect and disseminate information, has to exist. While these analysts are just as likely to make mistakes as the firm, they presumably should have a greater incentive to unearth bad news about the firm and to disseminate that information to their clients. For this system to work, analysts have to be given free rein to search for good as well as bad news and to make positive or negative judgments about a firm.

Making Markets more efficient

Just as better information cannot be legislated into existence, markets cannot be made more efficient by edict. In fact, there is widespread disagreement on what is required to make markets more efficient. At the minimum, these are necessary (though not sufficient) conditions for more efficient markets -a. Trading should be both inexpensive and easy. The higher transactions costs are, and the more difficult it is to execute a trade, the more likely it is that markets will be inefficient.

b. There should be free and wide access to information about firms.

c. Investors should be allowed to benefit when they pick the right stocks to invest in and to pay the price when they make mistakes.

Restrictions imposed on trading, while well intentioned, often lead to market inefficiencies. For instance, restricting short sales, where investors who don't own a stock can borrow and sell it if they feel it is overpriced, may seem like good public policy, but it can create a scenario where negative information about stocks cannot be reflected adequately in prices.

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