CHAPTER FOUR

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1 CHAPTER FOUR EFFICIENT MARKETS, INVESTMENT VALUE AND MARKET PRICE

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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. - PowerPoint PPT Presentation

Transcript of CHAPTER FOUR

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CHAPTER FOUR

EFFICIENT MARKETS, INVESTMENT VALUE AND

MARKET PRICE

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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

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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 left to the lower right.

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The Market Demand Schedule for IBM Stock

$0

$20

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$120

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IBM

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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

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The Market Supply Schedule for IBM Stock

$0

$20

$40

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IBM S

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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.”

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How Market Price Is Determined for IBM Stock

0

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10 20 30 40

buyerssellers

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D

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DEMAND AND SUPPLY

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

• more optimistic (pessimistic) investors enter the market

• investors income may change

• the supply or demand for a complementary product for the stock changes

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DEMAND AND SUPPLY

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

• the profitability of IBM changes

• the management of the firm changes

• the costs of the firm change

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MARKET EFFICIENCY

• WHAT IS AN EFFICIENT MARKET?– It is allocationally efficient when it distributes

funds to the most promising investments

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MARKET EFFICIENCY

– Informationally (externally) efficient• distributes information quickly and widely

• prices adjust rapidly in an unbiased manner

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MARKET EFFICIENCY

– Operationally (internally) efficient• brokers and dealers compete fairly

• low transaction costs

• high speed transactions

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MARKET EFFICIENCY

• THE EFFICIENT MARKET MODEL:– Concerned with Informational Efficiency

–Also known as:• Efficient Market Theory (EMT)

• Efficient Market Hypothesis (EMH)

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MARKET EFFICIENCY

• THE EFFICIENT MARKET MODEL:– Assumptions:

• costless access to available information

• capable analysis skills by participants

• close attention to market prices which adjust appropriately

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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

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MARKET EFFICIENCY

THE EFFICIENT MARKETMODEL

all informationinsider

information

public information

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THE FAMA MARKET MODEL

• THE FAMA MARKET MODEL (EQUATION)

tjttjttj prEpE ,1,1, |1|

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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 (

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THE FAMA MARKET MODEL

• E(rj,t+1) is determined by

• the information set available to investors at the start

of period

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THE FAMA MARKET MODEL

• Implication:• if markets are perfectly efficient, investors cannot 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

t t j t j t jp E p x | 1 , 1 , 1 ,

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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

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THE FAMA MARKET MODEL

• SECURITY PRICE CHANGES ARE A RANDOM WALK– What happens when new information arrives

changing t ?

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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

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THE FAMA MARKET MODEL

• SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS:– Investors will make a fair return but no more on

their investments

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THE FAMA MARKET MODEL

• SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS:– by searching for inefficiencies, investors

ensure market efficiency

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THE FAMA MARKET MODEL

• SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS:– publicly known investment strategies cannot

generate abnormal returns

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THE FAMA MARKET MODEL

• SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS:– some investors will display impressive

performance records

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THE FAMA MARKET MODEL

• SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS:– professional investors should fare no better than

ordinary investors when selecting securities

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THE FAMA MARKET MODEL

• SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS:– past performance is not an indicator of future

performance