Transcript the fama market model

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
$120
$100
$80
$60
IBM
$40
D
$20
$0
10
20
30
40
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
$120
$100
$80
$60
IBM S
$40
$20
$0
10
20
30
40
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
120
100
80
buyers
sellers
60
40
20
0
10
20
30
40
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
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
MARKET 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 manner
MARKET EFFICIENCY
• Internally efficient
brokers and dealers compete fairly
low transaction costs
high speed transactions
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
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
MARKET EFFICIENCY
THE FAMA MARKET MODEL

THE FAMA MARKET MODEL
(EQUATION)


E  p j ,t 1 |  t   1  E r j ,t 1 |  t  p j ,t
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(rj,t+1) is determined by
the information set available to investors at
the start of period
THE FAMA MARKET MODEL

Implication:
if markets are perfectly efficient, investors can
not earn abnormal returns based on the
information set because
x j ,t 1  p j ,t 1  E p j ,t 1 | t 
where xj,t+1 is the difference in price at t+1
between what is the price and what investors
expect
THE FAMA MARKET MODEL
• Implication:
In an efficient market
Ex j ,t 1 | t   0
there will be no expected under or
overvaluation of securities based on the
available information set
THE FAMA MARKET MODEL

SECURITY PRICE CHANGES ARE A
RANDOM WALK
• What happens when new information
arrives changing ft ?
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
THE 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

SUMMARY OBSERVATIONS ABOUT
EFFICIENT MARKETS:
• past performance is not an indicator of
future performance
END OF CHAPTER 4