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
$1 2 0

$1 0 0

$8 0

$6 0 IB M

$4 0

$2 0

$0
D
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
$1 2 0

$1 0 0

$8 0

$6 0 IB M S

$4 0

$2 0

$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

100 S
80
b u y e rs
60
s e l l e rs
40

20 D
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

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 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

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 MARKET EFFICIENCY

THE EFFICIENT MARKET

MODEL

public information

all
insider information
information

16
 MARKET EFFICIENCY

THE EFFICIENT MARKET

MODEL

public information

all
insider information
information

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 (

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 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 |  t 
where xj,t+1 is the difference in price at t+1 between what is the
price and what investors expect

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 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

21
 THE FAMA MARKET MODEL

• SECURITY PRICE CHANGES ARE A

RANDOM WALK
– What happens when new information arrives
changing t ?

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

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 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