Tutorial 11

Question 1

The failure of managers to release bad news is a version of the adverse selection
problem. Such failure indicates that the securities market is not working well.

Required
a. Why might a manager withhold bad news?

Managers may withhold bad news when there is low litigation risk from being discovered to
have withheld and :
• Due to career concerns and reputation damage, managers have an
incentive to delay the release of bad news in the hope goods news will
eventually arrive and camouflage/bury he bad news (see expansion of
this point further below)
• To conceal evidence of shirking, if the bad news results from low
manager effort.
• To delay a fall in share price, which possibly affect manager
compensation in a specific year
• To enable insider trading profits.

Note an important constraint on the release of bad news is that litigation risk can motivate
managers to quickly reveal bad news

b. When will the disclosure principle operate to motivate the manager to report bad
news? Why, in practice, does the principle not always hold?

The disclosure principle will completely eliminate a manager’s incentive to withhold bad
news if the following conditions hold:
• The information can be ranked from good to bad in terms of its
implications for firm value.
• Investors know that the manager has the information.
• There is no cost to the firm of releasing the information.
• Market forces and/or penalties ensure that the information released is
truthful.
• If the information affects variables used for contracting (e.g., share
price or covenant ratios), release of the information does not impose
increased contracting costs on the firm.
Then, the market will interpret failure to disclose as indicating the worst possible
information. To avoid the resulting impact on share price, all but the lowest-type
manager will disclose.
If one or more of the above requirements is violated, the disclosure principle may not
completely eliminate the withholding of bad news. This will be the case when:
 • The information is proprietary. Then, there is a threshold level below
which the news will not be released (Verrecchia (1983)).
• If the market is not sure whether the manager has the information,
there is a threshold below which the news will not be released, even
though it is non-proprietary. The motivation to release non-proprietary
information arises from its effect on firm value (Pae, 2005).
• If release of information may trigger the entry of competitors, the firm
may only disclose a range within which the news lies. In this sense,
disclosure is not truthful (Newman and Sansing (1993)).
• If contracts, such as manager compensation, are based on share price
and if releasing the news will increase the firm’s contracting costs
(e.g., a forecast’s effect on share price may swamp the ability of share
price to reflect manager effort), it may not be in the firm’s interests to
release the information (Dye (1985)).
We may conclude that while the disclosure principle has the potential to motivate full release
of bad news, in practice it is only partially effective due to the number of scenarios where it
breaks down.
Question 2

On September 15, 2004, the Dow Jones Industrial Index suffered its largest fall in a
month, dropping by 0.8% or 86.8 points. The Standard & Poor's 100, 400, and 500
indices also dropped by similar amounts.

According to media reports, the market declines were triggered by The Coca-Cola
Company and Xilinx Inc. (a large producer of computer logic chips and related
products). These companies announced that sales and profits for the third quarter 2004
would be less than analysts’ estimates

Required
a. What is a stock index and how are they constructed? How does the Dow Jones
Industrial Index differ from the S&P 100, 400 and 500 index?

A stock index is a collection equity securities “nominally” put together to track the
average performance and price of that collection of securities. There are 100s if not
1000s of stock indexes across the world capturing different collections of firms in and
across different countries.

Each stock index is put together by an “external party”. Some common indexes are
put together by a private company Standard & Poors, the Financial Times, and MSCI.
There are no limitations on who may combine and publicise an index, but several
indexes have risen to prominence due to their frequent citation and usage.

The Dow Jones Industrial Index is one put together by media group Dow Jones. It
focuses on industrial companies, however, this has now given way to inclusion of a
range of companies including financial companies. It includes 30 large companies
from the United States, but is not necessarily the 30 largest as Dow Jones is selective
about the inclusion of companies. Without complicating matters, the value of the
index is the sum of the stock prices of the firms within the index (controlled for stock
splits etc). Thus, the movements in the index are effectively stock price weighted.

In contrast, the S&P indexes are generally made up of the X largest companies, as
measured by the market capitalization of their stock. Thus, the S&P 500, another
common stock index, is made up of the 500 largest US companies. An Australian
equivalent is the ASX S&P 200. These indexes are “value weighted” and therefore,
the largest companies have the most influence on the performance of the index.

In general, these indexes are used to track the performance of the market as a whole,
or on average. They give a good representation of general market sentiment. As such,
they are also the basis for a large number of derivative contracts such as futures
contracts and options, allowing investors to hedge market risk, or speculate on market
movements at large. You cannot “buy the index” literally, but you can invest in
securities, like the derivatives, with prices that follow these portfolios. In the case of
direct investments, this would be buying a unit in a fund that purchases the same
stocks that make up the index.
b. Why did the whole market decline?

The market declined because the announcements of lower sales and profits contained
market-wide information. If sales and profits were lower for these two large and
diverse firms, this suggests that many other firms will also suffer from reduced
business activity. As investors bid down the share prices of all firms deemed to be
affected by this reduced activity (including Coca-Cola and Xilinx), the market index
was dragged down.

Note: An alternative, less satisfactory, answer is that only the share prices of the two
companies in question declined in reaction to the firm-specific information contained
in the announcements. Since these firms are quite large, and are part of the market
index, the decline in their share prices pulled the market index down. The magnitude
and breadth of the market decline seems inconsistent with this argument, however.

c. What market failure does this episode illustrate? Use the concept of externalities
to explain why this is a failure.

This episode illustrates the problem of externalities. The information released by

Coca-Cola and Xilinx about their own prospects also contained implicit information
about the prospects of other firms. The 2 companies receive no reward for this
economy-wide information, consequently there is no incentive for them to release
more than a minimum disclosure. For example, perhaps more timely release, more
information about why they felt sales and profits will decline, having their auditors
attest to the information, and/or breaking the sales and profits down by company line
of business or division, would have helped the market to assess the extent to which
other companies would be affected.
Question 3

In February 1998, Newbridge Networks Corporation, a telecommunications equipment

maker based in Kanata, Ontario, announced that its revenues and profits for the
quarter ending on February 1, 1998, would be substantially below analysts' estimates.
Its share price immediately fell by 23% on the Toronto and New York stock exchanges.
The sale, in December 1997, of over $5 million of the company's shares by an inside
director of Newbridge was widely reported in the financial media during February
1998. Details of sales by other Newbridge insiders, including its CEO, during previous
months were also reported. The implication of these media reports was that these
persons had taken advantage of inside information about disappointing sales of a new
product line.

Required
a. Which source of market failure is implied by these media reports of insider
trading?

The market failure derives from adverse selection. Investors felt that managers were
engaging in selective disclosure. That is, inside information was released to certain
individuals, such as analysts, who had the opportunity to take advantage of it before
passing it on to the market. This practice increased estimation risk for ordinary
investors, causing them to lower the amount they were willing to pay for all shares
and, in extreme cases, leave the market. In effect, the market was not working as well
as it should.

b. What effects on investors, and on the liquidity of Newbridge shares, would media
reports of such insider sales be expected to create?

Market liquidity will be reduced by this practice. Both market depth and the bid-ask
spread will be affected. The depth component of market liquidity will fall as ordinary
investors leave the market. The bid-ask spread component will rise as dealers (who set
the spread) and investors perceive that inside information is in the hands of a group of
analysts and institutional investors who will, presumably, use it for their own advantage
at their expense.

Liquidity is important if markets are to work well because:

• Market liquidity (depth) enables large investors to buy and sell large blocks of
shares without affecting the market price. If large investors cannot do this, their demand
for shares will fall, since they will have to pay more to buy and will receive less if they
sell. Lower demand exerts downward influence on share prices.

• Increased bid-ask spread increases transactions costs for investors, further

lowering demand for shares.

• Lower market liquidity, and lower share prices that follows, increases firms’
costs of capital, with negative effects on the economy.