EMH and Off Balance Sheet

¶ … EMH and off balance Sheet Financing

The studies over the fluctuations of prices in the stock markets have attracted researcher since a considerable period of time. Presently the financial market research have been an exciting field involving query of the past consequences and proposals of the new solutions. However, considerable debate is going on over the hypothesis of market efficiency. The speculative market strategy propounded by John Maynard Keynes necessitated complete reformulation in view of the unstable characteristics of the stock market. In view of its growing importance in the context of the stock market behavior the field of study of market efficiency worth detail analysis with reference to its emerging lines of thought. [the Efficient Market Hypothesis on Trial: A Survey] the concept of Efficient Market Hypothesis traces its origin to the Ph.D. dissertation of Eugene Fama. The point of reference put forth by Fama made it clear that amidst an active market situation involving fully aware and smart investors the securities are visualized to have appropriately priced and also reflects all available information. [the Efficient Market Hypothesis & the Random Walk Theory]

Fama observed that when a market is efficient no information or analysis is anticipated to result in out performance of an appropriate paradigm. According to him an efficient market is taken to mean the existence of innumerable balanced, profit maximizers actively under competition each attempting to forecast the future market prices of individual securities. There exists a mechanism where the prevailing information is freely available to all the participants. The resulting competition among the smart and fully aware participants in the efficient market paves the way to a situation where at any particular point of time the real value of the individual securities reflect the impact of information on the basis of both on events that have already transpired and on events that as of now the market anticipates to take place in the future. Thus the efficient market at any point in time reflects that the actual value of a security is considered to be a good measure of its intrinsic value. [the Efficient Market Hypothesis & the Random Walk Theory]

The financial market deals with the exchange of capital and credit that comprises of the money markets and the capital markets. The money market deals with the short-term debt securities that are particularly regarded as secured and a highly liquidated investment. The capital market on the other hand deals with the long-term debts or securities. The market efficiency implies to a condition where in the current prices reflect all the openly available information about a security. The market efficiency is based on the basic principle that the competition drives all information into the price rapidly. The best price that the investors afford in a financial market in respect of a financial asset is actually the present value of future cash payments that is discounted at a higher rate to reimburse us for the uncertainty in the cash flow projections. In this way the financial market actually deals with the trading of actual information as a commodity in financial market for the future cash flows and information about the level of certainty. The financial markets become efficient when new information is rapidly integrated in to the prices so as to make itself the information. The present market price, in other words, reflects the all presently propounded information. In such circumstances the prevailing market price in any financial market could be the most-unbiased estimation of the value of the investment. [Efficient Market Hypothesis]

The securities markets are strangled with innumerable smart, well-remunerated and fairly skilled investors in search of under and over values securities for trading. The market is said to be more efficient when there exists more number of participants and faster is the propagation of information. A prolonged debate about market efficiency gives rise to the hundreds and thousands of the empirical studies with a view to determining whether the specific markets are in fact efficient and if so to what magnitude. Paradoxically, the efficient markets if believed by each and every investor to be efficient obvert the very idea of efficiency and the market is not efficient, since no one attempts to analyze the securities. In reality the market efficiency depends upon market participants those assume the market to be inefficient and engage in trading of securities with a view to outperforming the market.

Robert C. Higgins in his publication, Analysis for financial Management depicts the market efficiency to describe the process of response of the prices in competitive market to the infusion of new information. He symbolized the advent of new information into the competitive market to the advent of a lamb chop to a group of flesh eating piranha, the investors being the representative for piranhas. As soon as the lamb chop reaches the water, there occurs much hue and cry and chaos while the piranhas are consuming the meat. Once the meat is finished leaving only the bone, the water becomes stable. This happens also in case of the market. Once the new information approaches the competitive market there is much confusion as the investors purchase and sells the sureties basing on the news resulting in significant fluctuation in the prices. Once the prices become stable and equilibrated the information is discarded just like the worthless bone. [the Efficient Market Hypothesis & the Random Walk Theory]

The further analysis of the old information fetches no valid intelligence similar to the fact that the biting on the left out bone will fetch no more meat. However, practically speaking no market is said to be either perfectly efficient or completely inefficient. It is evident that all the markets are efficient to a certain degree and some markets are observed to be more efficient than that of the others. In stead of being an issue of black or white this is symbolized to be the concerned with shades and gray. Where there is deficiency in market perfection the smarter investors thrive to outperform the comparatively ignorant investors. To illustrate, the government bond markets are visualized to be extremely efficient while the real estate and venture capital markets having no continuous markets are perceived o be less efficient due to the fact that the participants are having varying degrees of information. The argumentation over efficient market significantly influences the decision between the active and passive investing.

The active managers consider that the less efficient markets extend enough scope to the efficient managers to outperform in the market. But it is quite significant to acknowledge that a majority of the active managers amidst a given market condition under perform the appropriate paradigm in the long run irrespective of the fact of efficient or inefficient market. This is so because the active management is regarded as a zero-sum game in which the participant is visualized to make profit only when another less fortunate active participant to lose. It is also quite evident that with addition of costs even the marginally successful active managers are seen to under-perform. It is worthwhile that the investment professionals should find out the part played by the efficient markets.

The acceptance of the Efficient Market Hypothesis is justified on the ground that the primary role of a portfolio manager is the basic responsibility of the portfolio manager is to analyze and invest appropriately based on the basis of the tax considerations of the investor and the risk profile. The optimal portfolios are expected to change with the influence of elements like age, tax bracket, risk aversion and employment. The liability of the portfolio manager in such efficient market is to modify a portfolio to cater to such requirement rather than just beating the market. [the Efficient Market Hypothesis & the Random Walk Theory]

The Efficient Market Hypothesis has been taken as one of the fundamental base in the current financial economic analysis. In 1960 Fama first afford to explain the term in terms of reaction of the market prices to the newly available information. The market is said to be efficient when the possible responses to the market prices to the advent of new information is immediate and unprejudiced. The Efficient Market Hypothesis entails the basic ideology that the information is instantaneously and efficiently integrated into the asset prices at any particular point in time so that the old information is not used to forecast any future price movements. Basing on this ideology the economists attempt to distinguish between three forms of Efficient Market Hypothesis basing on the magnitude and level of available information. The weak form of Efficient Market Hypothesis specifies that the prevailing asset prices already reflect the past price and volume information.

The information integrated with the past trend of prices of a security is completely reflected in the prevailing market price in respect of the security. The concept of weak form is attached to this in view of the fact that the security prices at this stage are considered to be the most publicly and easily accessible pieces of information. This indicates that none is capable of outperforming the market with the use of something that 'that everybody else knows'. Still there exists a number of financial analysis those study the past trend of stock prices and the trend in trading volume as an effort to generate profit. Such technical analysis is viewed by Efficient Market Hypothesis as not effective in forecasting the variations in the fluctuations of future prices. The semi-strong form of Efficient Market Hypothesis reflects that all openly available information is already integrated into the asset prices. Speaking other way, all openly available market information is completely reflected in the current price of the securities.

The public information depicted not only the past prices but also includes the data published in the financial statements of the company, the declarations made in the company, economic and others factors. It also specifies that none is capable of outperforming the market with utilization of the information that everybody knows. This ensures that the financial statements of the company are not considered to be of much use in predicting the future trends of price fluctuations and securing high investment returns. The strong form of Efficient Market Hypothesis specifies that the private information or insider information is rapidly integrated into the market prices and therefore is not utilized to gather abnormal trading profits. Similarly, all information irrespective of public or private is fully reproduced in the prevailing market price of the securities.

This implies that the insider that is the management of the company even is not capable of taking advantage from the information they retain. They are not able to take the benefits of availing the latest information such as the decisions made just ten minutes ago so as to effectively make profit. The underlying principle behind the hypothesis is that the market predictions are unprejudiced. Therefore, the information is integrated and assessed into the market price in much more purposefully and enlightening way than the insiders in the management itself retains. An extension of the Efficient Market Hypothesis is seen in the random walk model which upheld the truism that the markets can never be persistently crashed, making the arbitration impossible and the 'free lunches' are generally unavailable. [Efficient Market Hypothesis]

The strong form of Efficient Market Hypothesis indicates that the securities prices integrate all the available information. It is, however, quite evident that the insiders those in the management have enough scope to benefit in terms of higher profits from the available trading on information not yet incorporated into the market prices. Seyhun, therefore, viewed that the strong form of Efficient Market Hypothesis cannot exist amidst real world phenomenon which can not be considered as unprivileged. Efforts have also made to include the weak form of Efficient Market Hypothesis in the current research analysis, incorporating the tests of market efficiency. The extension of the concept of the weak form was visualized by Fama in 1991 for incorporating predictions future returns with the use of accounting or macro-economic variables However, widespread differences of opinion prevails on the magnitude of market efficiency. This is further aggravated by the problem of joint hypothesis.

The evaluation of market efficiency involves an asset pricing model. If the trend is against the market efficiency it is inferred that either the market is inefficient or it may be that the model is quite erroneous. Ample research findings have been advanced to substantiate the inefficiencies involved in the model making the efficacy of the model suspicious. However, among all these three forms of the Efficient Market Hypothesis, the semi-strong form of Efficiency Market Hypothesis is considered to constitute the fundamental basis of the most of the empirical studies. The semi-strong form of Efficient Market Hypothesis assumes that the security prices incorporate all the openly available information. There exist no undervalued or overvalued securities that obvert the trading rules to influence for superior returns. A release of new information is completely integrated into the price rapidly. The advent of the updated information facilitated evaluation that has evidenced profound influences over the stock prices instantaneously. [the Efficient Market Hypothesis on Trial: A Survey]

The Efficient Market Hypothesis infers that none can outperform the market on the basis of the security selection or through market timing. It is seen that the Efficient Market Hypothesis involves many negative inferences that influence the investment strategies considerably. Normally the influence of Efficient Market Hypothesis can be perceived in two directions. Firstly it is from the investor's perspective. The past trend with regard to the price and volume in respect of trading is considered as the base for forecasting the prospective prices. The indication of random walk recommends that the prices in respect of the securities are influenced considerably the information. The information that is considered favorable enhances the price and unfavorable information on the other hand declines the price. On this jargon it is considered proper to assess the value of the technical analysis as a technique for selecting the security investments.

The fundamentals analysis involves utilization of the market information so as to determine the intrinsic value of securities in order to determine those securities that are undervalued. Moreover, the form of semi-strong market efficiency indicates that the fundamentals analysis cannot be used to outperform the market. The equity research and valuation in an efficient market are perceived to costly affairs and entails no advantage. The probability of attaining an undervalued stock is considered only 50%. It is perceived that most of the time the advantages accrued out of the benefits from information collection and equity research may not even surpass the costs incurred in the research activity. The passive investment strategy is recommended to be followed by the investors as the best available investment strategy that does not try to beat the market. The investors are required not to select the securities randomly in consonance with their risk aversion or the tax positions. This however, does not necessarily imply that there is lack of any portfolio management.

Having randomly diversifying securities, carrying little or no information cost and minimal execution costs so as to optimize the returns, this is regarded as the superior strategy. No value addition is visible in case of the portfolio managers and investment strategists. In order to match the desire risk level of the investor an inflexible buy and hold policy is not considered optimal. Moreover, the portfolio manager should choose a portfolio that is motivated towards the time and risk profile of the investor. Secondly, the influence of the Efficient Market Hypothesis is perceived from the Financial Managers Perspective. It should be understood by the managers that the response of the markets may be to under react or over react to information. The share price of the company said to reflect the information about their announcements.

The performance of the company can be assessed from the trend of the share prices during the past periods and the management is considered liable for it. The issue of new shares is required to be avoided by the managers when the share is under priced. This is visualized to have aggravated the situation. In general conditions thus the Efficient Market Hypothesis provides essential approach to the pricing behavior. Under these circumstances the investors expect only a normal rate of return while the company is anticipated to attain the appropriate value for the securities. Thus the Efficient Market Hypothesis entails that the published reports of financial analysts do not influence significantly the prices of securities recommending the investors not to attempt to outguess the market, buy and hold and diversify with no load mutual fund. [Efficient Market Hypothesis]

The off-balance sheet financing also commonly known as synthetic lease is considered to be a loan for IRS purposes. However, it resorts to lease documentation and also processed in consonance with the lease accounting. The off-balance-sheet financing is seen to extend the lowest probable cost of possession to the corporations involved in trade. The peculiar savings in respect of off-balance sheet financing are visualized to be at the range of 30-50% in comparison to the traditional lease. The off-balance sheet financing entails several benefits in respect of the financial reporting as well as for the taxation purposes. The benefits accrued in respect of the financial reporting includes among others that it is not necessary that the real estate is not shown in the balance sheet. Thus the lessor becomes the owner in this case. This has the evidence of better balance sheet adjustments in the form of saving of cash and resulting in the improvements of the conventional measure.

Since no real estate is involved the earning of the companies are not visualized to decline as a result of the depreciation. This ensures higher earnings to the companies and EPS. This also results in the enhanced stock price and market valuation. The advantages of the off-balance sheet financing are also visualized in connection with tax payments. Since the user owns the real estate the companies resorting to off-balance sheet financing has substantial benefit in respect of the taxation. Besides the taxation laws incorporate the deductions as a result of the depreciation thus entailing lower taxes and improved cash flows. [Off-Balance-Sheet Financing (Synthetic Lease)]

It has been seen during the past several years that the most of the banks in U.S. As well as from abroad are extending actively the off-balance sheet financing for the corporate real estate acquisition, construction and expansion. Such means of structure finance is considered much alluring to the corporate sector concerned with real estate since if properly organized as a real 'synthetic' leasing transaction the lessee corporate user is able to pay the rental payments due to the lessor under the lease and the balance sheet is actually not influenced by the real property asset or its ownership or by the prevalence of the mortgage debt. The lessee corporate is capable of holding all the tax benefits and bearing the burdens of ownership and also can depreciate the developments on the real property and to benefit from the appreciation in value with the subsequent purchase of real property and improvements made by the lessor besides from the resale to another party.

The Statement of Financial Accounting Standards No.13 -Accounting for Leases promulgated by the financial Account Standards Board -FASB during 1976 generalizes that a synthetic leasing transaction will not be eligible for the purposes of financial accounting unless the non-cancelable lease term is equal to or more than the seventy five percent of the estimated economic life of the property. This also necessitates that the operating lease in order to become the operating lease its ownership cannot be transferred to the lessee or entail a bargain price option to purchase. With a view to avoiding such automatic transfer of ownership to the lessee the synthetic lease is organized to entail the lessee with an option to either purchase the property at the end of the lease term or to sell it to another party. Moreover, a distinction is made between the 'indebtedness' and the 'borrowed money'.

With the interpretation of the indebtedness as the operating lease rental payments of the explorer, it has been held that this cannot be rewritten to read. It has also been held that the operating leases are not to be considered at the time of the supermajority provision and restricts the general right of the majority to govern corporate activities. The real estate synthetic leasing transaction is considered as a conventional financing device rather than a lease since the obligation of the lessee and rights were the similar as they would be under a more conventional mortgage. It confers the lessee to assume all operational insurance, liability, environmental, casually and management concerns in respect of the asset and for all practical purposes have the rights of ownership. [Off-Balance-Sheet Financing and Corporate Governance: Is it a Lease or Indebtedness?]

The concepts of off-balance sheet financing and the new audit committee responsibilities constitute two major issues pertaining to the prevailing management's discussion and analysis concerns. Attempting a discussion on these issues, Richard Langan the Business Group Leader at Nixon Peabody LLP, opined that the management discussion and analysis has become the key factor of company's disclosure which is being closely assessed by the Corporation Finance and Enforcement Divisions of SEC. The new disclosure conditions laid down by the SEC entail a particular response to the problems that were confronted over the past periods. To illustrate the new requirements relating to the off-balance sheet arrangements caused devastations in Energy and Dynegy cases.

The Item 303(a) (4) of Regulation S-K provides for the disclosure of the off-balance sheet arrangements. This made it mandatory for the companies to file the disclosure reports or registration statements with the SEC. The conditions laid down includes disclosure of the off-balance sheet arrangements at a time when the companies have or likely to have at present or prospective material influence over the financial conditions, results of operation, liquidity, capital resources, revenue or costs. It has been admitted by the SEC that these effects may possibly be entailed by the arrangements and may have only a less than 50% of the probability of the occurrence. However, it is essential that these are to be disclosed. [MD&a Issues, Off Balance Sheet Financing and New Audit Committee Responsibilities]

The stock option refers to the right of the employee but not necessarily the obligations to purchase share of stock at a future predetermined price. Evidently the value of the rights increases with the enhancement in the prices of the stocks. The stock options ensure the venture of the employees in the future of the company. As Alan Greenspan has emphasized and Warren Buffet has stressed upon the legality of financing transactions reflected in the financial statements the continuing issues of the independence of the auditors and the dependability of the suggestions and forecasts of the Wall Street analyst community. To supplement this one more item exists that is negatively influencing the reported earnings in almost all the companies being referred to as the accounting for stock options. The options provide a company the necessary scope and skills to grow. It is capable of using the scarce capital funds for growth and not the reparation costs. The prevailing accounting procedures entails that the value of an option is not necessitated to be shown as costs in the income statements of the company. [Accounting for Stock Options: Change at Whose Expense?] company, however, is necessarily indicate its incomes per share on the income statement on a diluted basic, the later taking into account the potential reduction in the ownership of existing shareholders as a result of the grant and exercise of the options. The accounting rules also necessitated the revelation of the supplementary facts with regard to the potential impact of options on earnings in the notes to the financial statements of the company. Taking in to consideration from the angle of taxation the exercising of an option by the employee normally enable the company to take a deduction from its gross income in lieu of the gain realized from the option attaining an advantage in the way of reducing its corporate income taxes. The empirical facts published in the New York Times show that about 50% of the top executives have received their compensations in the form of options. It has been estimated that an average CEO of the largest companies of the nation is receiving only $2 million per annum in terms of cash and the additional $10 to $15 million in terms of cash options.

Irrespective of the fact that the options are valued form of compensations, it is surprising to note that their costs are not reflected on the income statements as with other forms of compensation. A mathematical formula under the acronym of Black-Scholes model has been propounded to reasonably approximate the values of the options at the time of issue. Alan Greenpan is of the opinion that the inability to cost the stock options that has introduced a significant distortion in reported earnings having an increasing trend with growing prevalence of such form of compensation. In his recent deliberations he emphasized that the current accounting procedure with regard to the stock options were having real negative impacts deceiving the investors in paying unjustified prices for certain stocks and thus giving rise to the boom and the bust in share prices. In view of the devastations of ENRON and the reformulations on the corporate earnings he opined that the matter is not one of accounting but of financial stability. [Accounting for Stock Options: Change at Whose Expense?]