CHAPTER FOUR
EFFICIENT MARKETS,
INVESTMENT VALUE AND
MARKET PRICE
1
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
2
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.
3
The Market Demand
Schedule for IBM Stock
$120
$100
$80
$60
IBM
$40
$20
D
$0
10
20
30
40
4
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
5
The Market Supply
Schedule for IBM Stock
$120
$100
$80
$60
IBM S
$40
$20
$0
10
20
30
40
6
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.”
7
How Market Price Is
Determined for IBM Stock
120
S
100
80
buyers
sellers
60
40
D
20
0
10
20
30
40
8
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
9
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
10
MARKET EFFICIENCY
• WHAT IS AN EFFICIENT MARKET?
– It is allocationally efficient when it distributes
funds to the most promising investments
11
MARKET EFFICIENCY
– Externally efficient
• distributes information quickly and widely
• prices adjust rapidly in an unbiased manner
12
MARKET EFFICIENCY
– Internally efficient
• brokers and dealers compete fairly
• low transaction costs
• high speed transactions
13
MARKET EFFICIENCY
• THE EFFICIENT MARKET MODEL:
– Assumptions:
• costless access to available information
• capable analysis skills by participants
• close attention to market prices which adjust
appropriately
14
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
15
MARKET EFFICIENCY
16
MARKET EFFICIENCY
17
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)
18
THE FAMA MARKET MODEL
• E(rj,t+1) is determined by
• the information set available to investors at the start
of period
19
THE FAMA MARKET MODEL
• Implication:
• if markets are perfectly efficient, investors cannot earn
abnormal returns based on the information set because
x j ,t 1  p j ,t 1  E  p j ,t 1 | F t )
x
where j,t+1 is the difference in price at t+1 between what is
the price and what investors expect
20
THE FAMA MARKET MODEL
– Implication:
• In an efficient market
E x j ,t 1 | F t )  0
• there will be no expected under- or overvaluation of
securities based on the available information set
21
THE FAMA MARKET MODEL
• SECURITY PRICE CHANGES ARE A
RANDOM WALK
– What happens when new information arrives
changing ft ?
22
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
23
THE FAMA MARKET MODEL
• SUMMARY OBSERVATIONS ABOUT
EFFICIENT MARKETS:
– Investors will make a fair return but no more on
their investments
24
THE FAMA MARKET MODEL
• SUMMARY OBSERVATIONS ABOUT
EFFICIENT MARKETS:
– by searching for inefficiencies, investors
ensure market efficiency
25
THE FAMA MARKET MODEL
• SUMMARY OBSERVATIONS ABOUT
EFFICIENT MARKETS:
– publicly known investment strategies cannot
generate abnormal returns
26
THE FAMA MARKET MODEL
• SUMMARY OBSERVATIONS ABOUT
EFFICIENT MARKETS:
– some investors will display impressive
performance records
27
THE FAMA MARKET MODEL
• SUMMARY OBSERVATIONS ABOUT
EFFICIENT MARKETS:
– professional investors should fare no better than
ordinary investors when selecting securities
28
THE FAMA MARKET MODEL
• SUMMARY OBSERVATIONS ABOUT
EFFICIENT MARKETS:
– past performance is not an indicator of future
performance
29