CHAPTER FOUR EFFICIENT MARKETS, INVESTMENT VALUE AND MARKET PRICE

DEMAND AND SUPPLY n 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 n 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 D

DEMAND AND SUPPLY n 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

DEMAND AND SUPPLY n THE INTERACTION OF SUPPLY AND DEMAND: The Market opens: 3 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

DEMAND AND SUPPLY n SHIFTS IN SUPPLY AND DEMAND: What may cause a change in demand? 3 more optimistic (pessimistic) investors enter the market 3 investors income may change 3 the supply or demand for a complementary product for the stock changes

DEMAND AND SUPPLY n SHIFTS IN SUPPLY AND DEMAND: What may cause a shift in supply? 3 the profitability of IBM changes 3 the management of the firm changes 3 the costs of the firm change

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

MARKET EFFICIENCY Externally efficient 3 distributes information quickly and widely 3 prices adjust rapidly in an unbiased manner

MARKET EFFICIENCY Internally efficient 3 brokers and dealers compete fairly 3 low transaction costs 3 high speed transactions

MARKET EFFICIENCY n THE EFFICIENT MARKET MODEL: Assumptions: 3 costless access to available information 3 capable analysis skills by participants 3 close attention to market price which adjust appropriately

MARKET EFFICIENCY n THE EFFICIENT MARKET MODEL: Investment Value 3 the present value of the security’s future returns as estimated by informed investors 3 a market is said to be efficient when the investment value equals the market value at all times

MARKET EFFICIENCY

THE FAMA MARKET MODEL n THE FAMA MARKET MODEL (EQUATION)

THE FAMA MARKET MODEL n In words - 3 The expected price for any security E(r) 3 at the end of the period (t+1) 3 is based on the security’s expected normal rate of return during that period E(r j,t+1 )  given the information set at time t ( 

THE FAMA MARKET MODEL n E(r j,t+1 ) is determined by 3 the information set available to investors at the start of period

THE FAMA MARKET MODEL n Implication: 3 if markets are perfectly efficient, investors can not earn abnormal returns based on the information set because where x j,t+1 is the difference in price at t+1 between what is the price and what investors expect

THE FAMA MARKET MODEL Implication: 3 In an efficient market 3 there will be no expected under or overvaluation of securities based on the available information set

THE FAMA MARKET MODEL n SECURITY PRICE CHANGES ARE A RANDOM WALK What happens when new information arrives changing  t ?

THE FAMA MARKET MODEL 3 In an efficient market the new information is incorporated into prices immediately. 3 positive and negative information are as equally probable 3 if temporary inefficiencies cause mispricing, investors seeking profit opportunities eliminate the opportunities

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

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

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

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

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

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

END OF CHAPTER 4