Price Forecasting

The Two Big Mine Fields

Traders believe either that prices can be forecast or that they cannot.

“Had a blow up” or “blew up” signify traders who have lost more than they can stand.

The Efficient Market Hypothesis (EMH) is for those who believe prices cannot be forecasted. Because mine fields are randomly distributed, a certain

number will emerge and others will blow up. The Inefficient Market Hypothesis (IMH) is for

those who believe prices can be forecasted. Individual mine locations may be unknown, but patterns

and certain causes and effects can be known.

Efficient Market Hypothesis

Random Walk Hypothesis (RWH) EMH codified into three major forms:

Weak Form—All past information is reflected in price discovery.

Semi-Strong Form—All past information as well as all current information is used to formulate prices.

Strong Form—All past and current information plus all knowable information is considered in the pricing process.

Inefficient Market Hypothesis

IMH theorizes that market prices are not determined with perfect information; prices are constantly evolving as more information becomes available.

Technical analysis is based on the belief that where the market has been in the past is the best indicator of where it will be in the future.

Fundamental analysis holds that price determination has a cause-and-effect relationship; once the cause is identified, the effects can be forecast.

Identified-Insider Traders—another form of IMH?

Using the Efficient Market Hypothesis

EMH is most commonly used in equity markets. Next Day Pricing assumes that tomorrow’s price will

be different than today’s. Short Run Minimum/Maximum Prices—where the

market has made a new high or low in the short run is a better guide for short run minimum and maximum price forecasts.

EMH believers use past short-run price movements only as a guide for general price level expectations.

(continued)

Using the Inefficient Market Hypothesis

(continued) IMH has little appeal to the general trading

population. IMH appeals primarily to academic

researchers.

Fundamental Price Forecasting: Supply and Demand

Economic theory concerns how the interaction between supply and demand determines price.

Supply Producer’s supply curve is upward sloping portion of his or her

marginal cost curve; the market supply curve will be the horizontal summation of all individual cost curves.

Price elasticity of supply—equal to the percentage change in quantity supplied due to a percentage change in price.

Fundamental price forecasters will concentrate on changes in production technology, changes in the price of major inputs, and changes in the number of producers.

(continued)

Fundamental Price Forecasting: Supply and Demand (continued)

Demand curves are derived from the consumers’ utility of a product—called Diminishing Marginal Utility.

Price elasticity of demand is the responsiveness of quantity changes to changes in

price. is equal to the percent change in the quantity demanded

due to a present change in price. The individual’s demand curve is determined by holding

income, tastes and preferences, and the prices of other goods constant.

The sum of all individual demands creates the market demand.

(continued)

Fundamental Price Forecasting: Supply and Demand (continued)

Price changes cause a change in quantity demanded, and the amount and the availability of substitutes will determine how responsive the change in quantity demanded will be.

Cross price elasticity of demand is the relationship between the price change of one commodity and the effect on quantity demanded of another product.

Substitutes—an increase in the price of one product induces an increase in the quantity demanded of another product.

Complements—an increase in the price of one product results in a negative change in the quantity demanded of another product.

Putting Supply and Demand Together

Perfect Market Model Perfectly competitive market is a marketplace with

many buyers and sellers who are not large enough to have any undue influence, vying for a homogenous product.

A workably competitive market may be a market with many buyers and few sellers or vice versa. However, if neither buyers nor sellers can exert any type of monopoly power, the results are similar to a perfect market.

All markets are composed of many different traders and different factors.

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Perfect Market Model (continued)

Arbitrage is the process of capturing excess economic profits between two or more markets. Traders who do this are known as arbitragers.

Arbitragers take advantage of the following market differences: Markets that are separated by space have spatial price

differences. Perfect spatial markets differ by the cost of transportation.

Temporal markets differ by time. They should differ by the cost of storage.

Form markets differ by the cost of processing.(continued)

Perfect Market Model (continued)

In perfect markets, spatial, temporal, and form markets differ by the costs of transportation, storage, or processing—no more, no less—and no excess economic profit exists.

In imperfect markets, markets have potential profits in them because the price differences between the markets are larger than the costs of transportation, storage, or processing, and arbitragers will exploit the excess profit away.

In not perfect markets, markets price differences are less than the cost of transportation, storage, or processing.

Arbitragers will keep spatial, temporal and form markets closely tied together. These actions by arbitragers cause derivative market prices and cash market prices to “tend to trend together.”

The Law of One Price

If the difference between two or more prices can be justified by cost, then the two prices are identical except for defensible costs.

The law of one price is simply another way of looking at the perfect market model.

It provides a starting point for arbitragers.

Artificial Price Floors

Artificial price floors are implemented by the government to change supply.

If an artificial price is set above the market equilibrium, a surplus will result (Figure 3-11).

If an artificial price is set below the market equilibrium, a shortage will result (Figure 3-12).

Price Movements

Most price movements are caused by a change in either supply or demand, rarely both. If the majority of a price movement is caused by a

change in supply, it is supply driven. If the majority of the price movement is caused by

a change in demand, it is demand driven.

Supply Driven—see Figure 3-13. Demand Driven—see Figure 3-14.

(continued)

Price Movements (continued)

Seasonal and Cyclic Movements Agricultural commodities have biological

characteristics that affect the production process. Seasonal movements are price activities that

occur within a calendar year or production period. Cyclic movements are price tendencies that occur

over several production periods or years.

Price Forecasters

Two major types of price forecasters: “gut” analysts econometric analysts

Gut analysts filter all of the various supply and demand shifters

through their brain to come up with a price estimate. Their forecasts are based on experience, judgment, and intuition.

have short-lived careers when they are bad at what they do.

Econometrics

Econometrics is the study of quantifying economic relationships.

This process involves the following: Determine the economic relationship. Determine the mathematical expression of the economic

model. Determine what data to use and the time frame of analysis

Econometrics is far more complex than these three steps; however, these areas are the crux of each analysis.

Technical Price Analysis

Technical analysis is based on the belief that where prices have been in the past can be used as a guide for the future direction.

The technical analyst believes that all information is embedded in the

price movement and that it is impossible to fully determine all the factors influencing price.

studies the effect of fundamental analysis.

Types of Technical AnalysisCharting

There are two types of technical analysis: charting and mathematical modeling.

Charting analysis: visualizes price information. Chart types:

single price charts bar charts point and figure charts candlesticks

The purpose of each charting tool is to express visually what a price movement looks like in order to determine how long a trend will continue. when a trend will reverse.

Types of Technical AnalysisMathematical Modeling

Three major categories of mathematical (or mechanical) modeling: Curve fitting—for a given set of past price

movements, an equation will be selected that best fits the data.

Moving averages—at least two averages of past prices (one short-term, one longer-term) are calculated; their intersection indicates a change in trend.

Oscillators—elementary arithmetic expressions used to measure the rate of change of prices.