The Information Problem

Market prices are based upon information, both public and private. In the world of classical theory, information about companies is revealed promptly and truthfully to financial markets. In the real world, there are a few impediments to this process. The first is that information is sometimes suppressed or delayed by firms, especially when it contains bad news. While there is significant anecdotal evidence of this occurrence, the most direct evidence that firms do this comes from studies of earnings and dividend announcements made by firms. A study of earnings announcements, noted that those announcements that had the worst news tended to be delayed the longest, relative to the expected announcement date.17 In a similar vein, a study of earnings and dividend announcements by day of the week for firms on the New York Stock Exchange between 1982 and 1986 found that the announcements made on Friday, especially after the close of trading, contained more bad news than announcements made on any other day of the

Public and Private Information: Public information refers to any information that is available to the investing public, whereas private information is information that is restricted to only insiders or a few investors in the firm.

17 Penman, S. H., 1987, The Distribution Of Earnings News Over Time And Seasonalities In Aggregate Stock Returns, Journal of Financial Economics, v18(2), 199-228.

week.18 This suggests that managers try to release bad news when markets are least active or closed, because they fear that markets will over react.

The second problem is a more serious one. Some firms, in their zeal to keep investors happy and raise market prices, release intentionally misleading information about the firm's current conditions and future prospects to financial markets. These misrepresentations can cause stock prices to deviate significantly from value. Consider the example of Bre-X, a Canadian gold mining company that claimed to have found one of the largest mines in the world in Indonesia in the early 1990s. The stock was heavily touted by equity research analysts in the United States and Canada, but the entire claim was fraudulent. When the fraud came to light in 1997, the stock price tumbled, and analysts professed to be shocked that they had been misled by the firm. The more recent cases of Enron, WorldCom and Parmalat suggest that this problem is not restricted to smaller, less followed companies and can persist even with strict accounting standards and auditing oversight.

The implications of such fraudulent behavior for corporate finance can be profound, since managers are often evaluated on the basis of stock price performance. Thus Bre-X managers with options or bonus plans tied to the stock price probably did very well before the fraud came to light. Repeated violations of investor trust by companies can also lead to a loss of faith in equity markets and a decline in stock prices for all firms.

Insiders Online Stocks Trading Tips

Insiders Online Stocks Trading Tips

We Are Not To Be Held Responsible If Your Online Trading Profits Start To Skyrocket. Always Been Interested In Online Trading? But Super-Confused And Not Sure Where To Even Start? Fret Not! Learning It Is A Cakewalk, Only If You Have The Right Guidance.

Get My Free Ebook


Post a comment