CHAPTER FOUR EFFICIENT MARKETS, INVESTMENT VALUE AND MARKET PRICE.

CHAPTER FOUR

EFFICIENT MARKETS, INVESTMENT VALUE AND MARKET PRICE

DEMAND AND SUPPLY

HOW IS THE DEMAND FOR SECURITIES DETERMINED?•Definition: the demand for a security

is a schedule of prices and quantities demanded by investors at all possible prices.

•the demand is determined by summing the individual schedules for all investors in the market

DEMAND AND SUPPLY

DEMAND SCHEDULES:•When all demand schedules in the

market are combined, the result is an aggregate table of prices and quantities demanded.

•When graphed, the curve slopes from the upper to lower price schedule.

The Market Demand Schedule for IBM Stock

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IBM

D

DEMAND AND SUPPLY

HOW IS THE SUPPLY OF SECURITIES DETERMINED?•Individual brokers hold a collection of

market orders to sell at all possible prices

•In combining the market orders, the resulting market supply graph curves upward and to the right

The Market Supply Schedule for IBM Stock

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IBM S

DEMAND AND SUPPLY

THE INTERACTION OF SUPPLY AND DEMAND:•The Market opens:

an open outcry system begins as – the clerk calls out the prices for IBM– if no buyer, clerk goes to next lower price– if no seller, clerk raises price– prices are called until the quantity demanded

equals the quantity supplied at the “right price.”

How Market Price Is Determined for IBM Stock

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buyerssellers

DEMAND AND SUPPLY

SHIFTS IN SUPPLY AND DEMAND:•What may cause a change in

demand?more optimistic (pessimistic) investors

enter the marketinvestors income may changethe supply or demand for a

complementary product for the stock changes

DEMAND AND SUPPLY

SHIFTS IN SUPPLY AND DEMAND:•What may cause a shift in supply?

the profitability of IBM changesthe management of the firm changesthe costs of the firm change

MARKET EFFICIENCY

WHAT IS AN EFFICIENT MARKET?•Allocationally efficient distributes

funds to the most promising investments

MARKET EFFICIENCY

•Externally efficientdistributes information quickly and

widelyprices adjust rapidly in an unbiased

manner

MARKET EFFICIENCY

•Internally efficientbrokers and dealers compete fairlylow transaction costshigh speed transactions

MARKET EFFICIENCY

THE EFFICIENT MARKET MODEL:•Assumptions:

costless access to available informationcapable analysis skills by participantsclose attention to market price which

adjust appropriately

MARKET EFFICIENCY

THE EFFICIENT MARKET MODEL:•Investment Value

the present value of the security’s future returns as estimated by informed investors

a market is said to be efficient when the investment value equals the market value at all times

MARKET EFFICIENCY

THE EFFICIENT MARKETMODEL

all informationinsider

information

public information

THE FAMA MARKET MODEL THE FAMA MARKET MODEL

(EQUATION)

tjttjttj prEpE ,1,1, |1|

THE FAMA MARKET MODEL In words -

The expected price for any security E(r)at the end of the period (t+1)is based on the security’s expected

normal rate of return during that period E(rj,t+1)

given the information set at time t (

THE FAMA MARKET MODEL E(rj,t+1) is determined by

the information set available to

investors at the start of period

THE FAMA MARKET MODEL Implication:

if markets are perfectly efficient, investors can not earn abnormal returns based on the information set because

where xj,t+1 is the difference in price at t+1

between what is the price and what investors expect

ttjtjtj pEpx |1,1,1,

THE FAMA MARKET MODEL

•Implication:

In an efficient market

there will be no expected under or overvaluation of securities based on the available information set

0|1, ttjxE

THE FAMA MARKET MODEL SECURITY PRICE CHANGES ARE A

RANDOM WALK•What happens when new information

arrives changing t ?

THE FAMA MARKET MODEL

In an efficient market the new information

is incorporated into prices immediately.

positive and negative information are as

equally probable

if temporary inefficiencies cause

mispricing, investors seeking profit

opportunities eliminate the opportunities

THE FAMA MARKET MODEL SUMMARY OBSERVATIONS ABOUT

EFFICIENT MARKETS:•Investors will make a fair return but

no more on their investments

THE FAMA MARKET MODEL SUMMARY OBSERVATIONS ABOUT

EFFICIENT MARKETS:•by searching for inefficiencies,

investors insure market efficiency

THE FAMA MARKET MODEL SUMMARY OBSERVATIONS ABOUT

EFFICIENT MARKETS:•publicly known investment strategies

cannot generate abnormal returns

THE FAMA MARKET MODEL SUMMARY OBSERVATIONS ABOUT

EFFICIENT MARKETS:•some investors will display impressive

performance records

THE FAMA MARKET MODEL SUMMARY OBSERVATIONS ABOUT

EFFICIENT MARKETS:•professional investors should fare no

better than ordinary investors when selecting securities

THE FAMA MARKET MODEL SUMMARY OBSERVATIONS ABOUT

EFFICIENT MARKETS:•past performance is not an indicator

of future performance

END OF CHAPTER 4