CHAPTER FOUR
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Transcript of CHAPTER FOUR
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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$20
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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