Abstract
This paper develops a theoretical analysis of share market price formation driven by accounting and market structures. Heterogeneous investors are assumed to discover and process fundamental information disclosed by accounting system of share-issuing entity. Information set available to share market investors for decision-making comprises then market-driven and firm-specific (non-market) information. On the one side, accounting system provides collective signal of fundamental information; on the other side, price system provides collective signal of market-driven information over time. Both jointly drive the formation of aggregate share market prices through limited knowledge, hazard, and social interaction. Numerical simulations are provided under alternative accounting designs (namely, historical cost and fair value accounting regimes), to derive implications and recommendations for the concept and occurrence of speculative bubbles and herd behavior; the cyclical effects of accounting regime on share market dynamics; and the “value relevance” of accounting information and its role in the formation of share market prices over time. This numerical statistical analysis contributes to shed light on accounting anomalies and fundamental analysis.
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Notes
Emergency Economic Stabilization Act of 2008, 3 October 2008, Sec. 132. Authority to suspend mark-to-market accounting: “(a) AUTHORITY—The Securities and Exchange Commission shall have the authority under the securities laws (as such term is defined in section 3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)) to suspend, by rule, regulation, or order, the application of Statement Number 157 of the Financial Accounting Standards Board [concerned with fair value measurements, NdA] for any issuer (as such term is defined in section 3(a)(8) of such Act) or with respect to any class or category of transaction if the Commission determines that is necessary or appropriate in the public interest and is consistent with the protection of investors.” Analogous decisions were taken by European authorities thereafter.
Accounting studies analyse an ‘unconstrained relationship’ when they delegate their implicit model of reference to applied econometric methods (usually linear regressions). They analyse a ’constrained relationship’ when they explicitly introduce a model which generates hypotheses (and restrictions) on the parameters to be estimated.
A further extension may develop a two-step modeling strategy, moving from fundamentals (\(Y\)) to further design the ways to represent them through accounting reporting and disclosure (\(f\)).
For sake of simplicity, we consider mark-to-market accounting and fair value accounting synonymously, under the label FVA. While mark-to-market accounting implies the use of observable market prices to measure current value of every asset and liability, fair value accounting includes the recourse to observable and unobservable inputs to reproduce that value.
This is not less restrictive than the widespread hypothesis of a fixed discount rate on the whole time period of analysis.
This model of price expectation \(E_{S_{t,I}}\left( p_{t+1}\right) \) results from a combination between a “first order adaptive model”: \(E_{t}(P_{t+1})=E_{t-1}(P_{t})+\beta ^{\prime }\left( P_{t}-E_{t-1}(P_{t})\right) \) where \(\beta ^{\prime }\) weights the revision of the most recent expectation error, and an “extrapolative expectation model”: \(E_{t}(P_{t+1})-(P_{t})=\gamma (P_{t}-P_{t-1})\) where \(\gamma \) weights the most recent price change (trend). With \(\gamma >0\), any market price increase results in increasing the price expectation.
This is equivalent to set \(\beta _{i}=0\) in Eq. (3), implying an “extrapolative expectation model” outside the market. This hypothesis increases heterogeneity between investors but remains a minor analytical assumption that is not critical for our theoretical frame or simulation findings.
A further extension may analyze changing pattern of individual price expectation, by considering transaction and information-treatment costs, as well as revision of individual parameters (including \(\varphi _{i}\)) according to individual learning or social interaction over time (Frydman and Goldberg 2008; Biondi et al. 2012). Biondi and Righi (2013) investigate simulation results across parameter space of \(\alpha _{j,t}\) (\(j=S,D\)) that is then assumed to depend on dominant market mood expressed by supply and demand sides through time.
This random error \(\epsilon _{t}\) could result here from the working of a drunk auctioneer!
Bubbles cannot be defined here through a collective concept of fundamental value that does no longer exist. They may be denoted according to the stability and resilience of share price formation over time.
After all, if all investors know (agree on) one unique fundamental value, why do they still need a share market to perform price-fixing and trades?
Biondi et al. (2012) further analyse a specific evolution of interacting individual opinions by allowing \(\alpha _{t}^{j}\) to vary across periods \(t\) according to the Galam model of social opinion dynamics.
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Appendix
Appendix
This appendix explains in further details the market clearing process designed by our approach. Formation of market clearing price \(p_{t+1}^{*}\) over time depends on aggregation of individual bids of demand and supply at each period \(t\). In particular, every shareholder (\(j=S\)) \(i\) wishes to sell if \(p_{t+1}^{*}\ge \left. E_{t}(p_{t+1})\right| _{i}^{S}\), while every prospective investor (\(j=D\)) \(i\) wishes to buy if \(p_{t+1}^{*}\le \left. E_{t}(p_{t+1})\right| _{i}^{D}\).
By assuming uniform distribution of individual investors within each group \(j=S,D\), individual price expectation (focal price) \(\left. E_{t} (p_{t+1})\right| _{i}^{j}\) of investor \(i\) belonging to group \(j\) may be rewritten as a function of expectations expressed by extreme investors \(i=0\) and \(i=1\) as follows:
with \(j=S\) (Inside), \(D\) (Outside); \(i,\varphi _{i}\in \left[ 0,1\right] \); \(\alpha _{t}^{j}\in \left[ 0,1\right] \); \(\beta _{i}^{j}\in \left[ 0;1\right] \); \(\gamma ^{j}>0\).
In this paper, we assume that \(\alpha _{t}^{j}=\alpha \in \left[ 0,1\right] \), \(\gamma ^{j}=\gamma =1\) and \(\beta _{i}^{D}=0\) \(\forall i\).Footnote 14 On this basis, individual price expectation (focal price) by individual investor \(i\) may be rewritten as:
where
Extreme values of \(\varphi _{i}=0,1\) define four extreme investors: two with \(\varphi _{i}=0\), which are “pure speculators” (either inside \(j=S\) or outside \(j=D\) the market) and do not care of fundamental signal \(F_{t}(\cdot )\); and two with \(\varphi _{i}=1\), which are “pure fundamentalists” (either inside or outside the market, that is, \(j=S\) or \(j=D\)) and attribute full confidence to fundamental signal \(F_{t}(\cdot )\) inferred by fundamental analysis. Since time \(t=0\) when share-issuing entity \(k\) offers its shares on the primary market, aggregate demand and supply depend on these four focal prices with \(i=0\) and \(i=1\) \(\forall j=S,D\) (shareholding/potential fundamentalist and shareholding/potential speculator), defined as follows:
All together, these focal prices determine a “marketable area” (that could not exist) where share exchanges are wished by some shareholding and potential investors (Fig. 6). Inside and outside the share market, investors observe the aggregate share market price \(p_{t}\) and the fundamental signal \(F_{t}(\cdot )\) of business firm \(k\). According to their own expectations on \(p_{t+1}\), they decide then whether change their position through selling or buying, or simply wait until the next period.
Share market design defines how trades may be eventually performed within the “clearing area” (Fig. 5). This design decides how orders passed by investors are satisfied within this clearing area. This area denotes the width of the share market possible pricing at period \(t\). By assuming linear distribution of investors for both potential demand side and potential supply side of the share market, aggregate supply \(x_{t+1}^{S}\) and demand \(x_{t+1}^{D}\)integrate individual bids as follows:
On this basis, aggregate clearing price arises from matching demand with supply (\(x_{t+1}^{S}=x_{t+1}^{D}\)):
Figures 6 and 7 show this matching between aggregate demand and supply. In particular, Fig. 5 shows the case when aggregate clearing price exists.
Figure 7 shows the case when aggregate clearing price does not. In the latter case, no share exchanges occur. Aggregate clearing price is then settled by some institutional market-making rule.
Please refer to Biondi et al. (2012) for full analytical development of this approach.
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Biondi, Y., Giannoccolo, P. Share price formation, market exuberance and financial stability under alternative accounting regimes. J Econ Interact Coord 10, 333–362 (2015). https://doi.org/10.1007/s11403-014-0131-7
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DOI: https://doi.org/10.1007/s11403-014-0131-7
Keywords
- Accounting information
- Asset pricing model
- Fundamentalism
- Chartism
- Large fluctuations
- Financial bubbles
- Market exuberance
- Market microstructure
- Historical cost accounting
- Fair value accounting
- Mark-to-market
- Accrual anomalies