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
$0
$20
$40
$60
$80
$100
$120
10 20 30 40
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
$0
$20
$40
$60
$80
$100
$120
10 20 30 40
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
0 20 40 60 80 100 120
10 20 30 40
buyers sellers
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 changesDEMAND 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 changeMARKET EFFICIENCY
WHAT IS AN EFFICIENT MARKET?
• Allocationally efficient distributes funds to
the most promising investments
MARKET EFFICIENCY
• Externally efficient
distributes information quickly and widely
prices adjust rapidly in an unbiased mannerMARKET EFFICIENCY
• Internally efficient
brokers and dealers compete fairly
low transaction costs
high speed transactionsMARKET EFFICIENCY
THE EFFICIENT MARKET MODEL:
• Assumptions:
costless access to available information
capable analysis skills by participants
close attention to market price which adjust appropriatelyMARKET 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 theinvestment value equals the market value at all times
MARKET EFFICIENCY
THE EFFICIENT MARKET MODEL
al l
information insider
information
public information
THE FAMA MARKET MODEL
THE FAMA MARKET MODEL (EQUATION)
p
j t t E r
j t t p
j tE
, 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(r
j,t+1) is determined by
the information set available to investors at the start of periodTHE FAMA MARKET MODEL
Implication:
if markets are perfectly efficient, investors can not earn abnormal returns based on the information set becausewhere
x
j,t+1 is the difference in price at t+1 between what is the price and what investorsexpect
j t t
t j t
j p E p
x , 1 , 1 , 1 |
THE FAMA MARKET MODEL
• Implication:
In an efficient market
there will be no expected under orovervaluation of securities based on the available information set
x j , t 1 | t 0
E
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 opportunitiesTHE 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
