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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.

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CHAPTER FOUR

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  1. CHAPTER FOUR EFFICIENT MARKETS, INVESTMENT VALUE AND MARKET PRICE

  2. 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

  3. 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.

  4. The Market Demand Schedule for IBM Stock D

  5. 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

  6. The Market Supply Schedule for IBM Stock

  7. 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.”

  8. How Market Price Is Determined for IBM Stock

  9. 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

  10. 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

  11. MARKET EFFICIENCY • WHAT IS AN EFFICIENT MARKET? • Allocationally efficient distributes funds to the most promising investments

  12. MARKET EFFICIENCY • Externally efficient • distributes information quickly and widely • prices adjust rapidly in an unbiased manner

  13. MARKET EFFICIENCY • Internally efficient • brokers and dealers compete fairly • low transaction costs • high speed transactions

  14. MARKET EFFICIENCY • THE EFFICIENT MARKET MODEL: • Assumptions: • costless access to available information • capable analysis skills by participants • close attention to market price which adjust appropriately

  15. 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

  16. MARKET EFFICIENCY

  17. THE FAMA MARKET MODEL • THE FAMA MARKET MODEL (EQUATION)

  18. 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 (F)

  19. THE FAMA MARKET MODEL • E(rj,t+1) is determined by • the information set available to investors at the start of period

  20. 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+1is the difference in price at t+1 between what is the price and what investors expect

  21. 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

  22. THE FAMA MARKET MODEL • SECURITY PRICE CHANGES ARE A RANDOM WALK • What happens when new information arrives changing ft?

  23. 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

  24. THE FAMA MARKET MODEL • SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS: • Investors will make a fair return but no more on their investments

  25. THE FAMA MARKET MODEL • SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS: • by searching for inefficiencies, investors insure market efficiency

  26. THE FAMA MARKET MODEL • SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS: • publicly known investment strategies cannot generate abnormal returns

  27. THE FAMA MARKET MODEL • SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS: • some investors will display impressive performance records

  28. THE FAMA MARKET MODEL • SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS: • professional investors should fare no better than ordinary investors when selecting securities

  29. THE FAMA MARKET MODEL • SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS: • past performance is not an indicator of future performance

  30. END OF CHAPTER 4

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