Agenda

1. Agenda • Collect • reaction papers • multiple choice questions • class participation forms for day 3 (Tuesday) • Discuss • Sunder • Lev • SEC readings

2. Spreads • What’s a spread? • the difference between the bid (buying) and ask (selling) prices set by the market maker. • A spread is positive when ask > bid and negative when bid > ask • Size of spreads reflects • extent of information asymmetry • cost of holding inventory • return to market makers’ human capital

3. The effect of spreads on volume and prices $ Demand Supply Ask deadweight loss P* Bid Volume Q** Q* Quantity purchased = Quantity sold

4. Setting spreads to build inventory $ Demand Supply Ask P* Bid Volume Q Q Q* S P Quantity purchased > Quantity sold

5. Setting spreads to cut inventory $ Demand Supply Ask P* Bid Volume Q Q Q* P S Quantity sold > Quantity purchased

6. The effect of information asymmetry on demand and supply $ Demand Supply Ask P* Bid Volume Q** Q* Quantity purchased = Quantity sold

7. Lee: 1 • Accounting is an artifact of civilization: it exists to serve human needs • Accounting activity is a social system • objectives are defined by social needs • carried out by specialized agents (professionals in modern terminology) • education and training requirements keep increasing as objectives become more complex and sophisticated • rights and obligations of agents defined by society

8. Lee: 2 • Business became more complex, more sophisticated concepts were needed: what attributes to measure? • What’s the goal? Decision making vs. performance evaluation vs. stewardship • With separation of ownership and control performance evaluation (profit earned) became crucial -- focus shifted to I/S. • Stewardship still important -- B/S retained. • Accrual accounting seen as incomplete, Cash flow statements acquire usefulness

9. Sunder: 1 • Accounting standards are political in nature, redistribute wealth and are costly to society. • Standards are costly • need a bureaucracy • bureaucrats’ incentives may be “wrong” • standards stifle innovation, preserve status quo. • Neither pure cost-benefit analysis nor Pareto-optimality is likely to be a useful crieterion on its own.

10. Sunder: 2 • Optimal level of standard setting trades off both the total costs and benefits as well as the distributional impact of standards. • What standards would be best requires good information on costs and benefits -- can standard-setter learn these truthfully? • Multiple mechanisms exist to set standards • common law, markets, referendum, legislation, judiciary, bureaucracy

11. Sunder: 3 • APB was responsive to user needs • “lack of independence” seen as a virtue • FASB is seen as an aggressive, overly active, costly, entrenched bureaucracy with a built-in “bias for action” and is losing support from key constituencies • Slow down standard setting. Markets will deal with many issues without need for standards.

12. Lev: 1 • Equality of opportunity for all investors is key to a well-developed capital market • Equality of opportunity comes from equitable distribution of information • Inequity is costly: cost of capital goes up as investors seek to protect themselves. Lower volume of capital supplied and demanded. The economy as a whole is worse off.

13. Lev: 2 • Why mandate disclosure? • reduce costs of information asymmetry • voluntary disclosure incentives inadequate (?) • How decide what to mandate? • information that investors value • management earnings forecasts or information that is valuable for predicting future payoffs • information large investors or bankers get • protect the interests of the least informed

14. Lev: 3 • How to measure disclosure effectiveness? • reduction in spreads, • increase in price informativeness • reduced returns to insider information • equalization of returns across comparable trading strategies

15. SEC: Chapter 1 (1) • SEC charter: Securities acts of 1933/34 • 33 Act: distribution, 34 Act: trading • Mandate: protect investors • Why regulation to protect investors? • (Lev vs. Sunder?) • Financial abuses preceding (and thought to have contributed to) 1929 crash. • Increased direct access to investors by firms.

16. SEC: Chapter 1 (2) • How? Regulate disclosure not merits • Why? Allow innovation, EMH. • Structure of the SEC? • operational arms are called divisions • corporate finance, investment management, market regulation, enforcement -- lawyers • staff are organized in offices • office of chief accountant, economist, general counsel -- these are the lawyers’ accountant, economist and lawyers respectively.

17. SEC: Chapter 1 (3) • How the SEC speaks: • FRRs (financial reporting releases) -- binding • AAERs (accounting and auditing enforcement releases) -- who’s been naughty and what their punishment will be. • ISRs (international series releases) -- all about them furrin’ firms and furrin’ markets. • SABs (staff accounting bulletins) -- interpretations, not official positions of the SEC.

18. SEC: Chapter 2 • Understand the arguments for and against raising capital from the public (going public). • Steps in the registration process and obligations of underwriters and management at every step. Especially note the restrictions relating to the quiet period. • Who or what is exempt? Know this.