1. EFFICIENT MARKETS, INVESTMENT VALUE AND MARKET PRICE
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 left to the lower right.

4. The Market Demand Schedule for IBM Stock

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?
It is allocationally efficient when it distributes funds to the most promising investments
Externally efficient
distributes information quickly and widely
prices adjust rapidly in an unbiased manner
Internally efficient
brokers and dealers compete fairly
low transaction costs
high speed transactions

12. Market Efficiency Operational or Internal Efficiency:
Due to high competition among brokers transaction costs are very low.
Security Markets shifted from fixed to negotiated brokerage commissions. US in 1975, France in 1985, UK in 1986, Japan in 1996.
The Bid-Ask spreads have also gone down from 1/8 to even 1/16 in recent years on June From Aug 24, 2000, minimum spread reduced to one cent.
Pricing or External Efficiency:
Pricing efficiency refers to markets where prices at all times fully reflect all available information that is relevant to valuation of securities.
In other words, efficient market results in security prices equal to their intrinsic values.
Active strategies yield as much as passive strategies or indexing strategy.

13. MARKET EFFICIENCY THE EFFICIENT MARKET MODEL: Assumptions:
All investors have costless access to available information about the future.
All investors are capable of analysis.
All investors pay close attention to market prices and adjust their holdings appropriately.

14. MARKET EFFICIENCY THE EFFICIENT MARKET MODEL:
Investment Value/Intrinsic 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

15. Three forms of Market Efficiency
Eugene Fama offers following forms of Market Efficiency.
Weak: Security prices reflect all information of past prices, (i.e. No investor can make abnormal returns using past price information.)
Semistrong: Security prices reflect all publically available information. (i.e. No investor can make abnormal returns using publically available information.)
Strong: Security prices reflect all information both public and private. (i.e. No investor can make abnormal returns using public or private information.)

17. An inefficiency ought to be an exploitable opportunity
An inefficiency ought to be an exploitable opportunity. If there is nothing investors can properly exploit in a systematic way, time in and time out, then it’s very hard to say that information is not being properly incorporated into stock prices”. Richard Roll
Financial markets are efficient because they don’t allow investors to earn above average returns without taking above average risks”. Burton Malkiel
The efficient markets theory holds that the trading by investors in a free and competitive market drives security prices to their true ’fundamental’ values. The market can better assess what a stock or a bond is worth than any individual trader.” Andrei Shleifer

18. MARKET EFFICIENCY
Note: If markets re strong-form efficient (SF), they are also semi-strong (SS) and weak-form (WF) efficient.

19. 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)
That is to say that :
“Security’s expected price E (r) at any future time (t+1) depends upon its expected rate of return E(rj,t+1), which is function of information set (good/bad) at time t (F). ”

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

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
What happens when new information arrives changing ft ?
SECURITY PRICE CHANGES ARE A RANDOM WALK
For information to be new, it must have element of surprise.
Arrival of new information, causes adjustments in security prices as investors respond to the impact of that information.
Investors’ demand and supply interactions eliminate any mispricing in security prices in very short time. Therefore the difference between the market value and intrinsic value disappears in a short span of time.

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
by searching for inefficiencies, investors ensure market efficiency
publicly known investment strategies cannot generate abnormal returns
some investors will display impressive performance records
professional investors should fare no better than ordinary investors when selecting securities
past performance is not an indicator of future performance

25. Criticism Market Anomalies: The size effect The value effect
The short term momentum
The long term reversal
The new issues puzzle
The weekend/holiday effect
The January effect

26. The Bottom Line
The efficient market hypothesis is a useful framework for modelling financial markets.
Like any model, the ’efficient market hypothesis is not a perfect description of reality; some prices are almost certainly ”wrong”.
However, it would be naive to think that prices are always wrong or that it is easy to exploit pricing errors. ” Instead of asking whether or not the market is efficient, the more relevant questions are:
how efficient is the market?
how does the market react to new information arrivals? and why?
what are the mechanisms that bring market prices to fundamental values?