CHAPTER FOURDEMAND AND SUPPLYSlide 3The Market Demand Schedule for IBM StockSlide 5The Market Supply Schedule for IBM StockSlide 7How Market Price Is Determined for IBM StockSlide 9Slide 10MARKET EFFICIENCYSlide 12Slide 13Slide 14Slide 15Slide 16Slide 17THE FAMA MARKET MODELSlide 19Slide 20Slide 21Slide 22Slide 23Slide 24Slide 25Slide 26Slide 27Slide 28Slide 29Slide 301CHAPTER FOUREFFICIENT MARKETS, INVESTMENT VALUE AND MARKET PRICE2DEMAND 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 market3DEMAND 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.4The Market Demand Schedule for IBM Stock$0$20$40$60$80$100$12010 20 30 40IBMD5DEMAND 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 right6The Market Supply Schedule for IBM Stock$0$20$40$60$80$100$12010 20 30 40IBM S7DEMAND 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.”8How Market Price Is Determined for IBM Stock02040608010012010 20 30 40buyerssellersSD9DEMAND 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 changes10DEMAND 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 change11MARKET EFFICIENCY•WHAT IS AN EFFICIENT MARKET?–It is allocationally efficient when it distributes funds to the most promising investments12MARKET EFFICIENCY–Informationally (externally) efficient•distributes information quickly and widely•prices adjust rapidly in an unbiased manner13MARKET EFFICIENCY–Operationally (internally) efficient•brokers and dealers compete fairly•low transaction costs•high speed transactionsMARKET EFFICIENCY•THE EFFICIENT MARKET MODEL:–Concerned with Informational Efficiency–Also known as:•Efficient Market Theory (EMT)•Efficient Market Hypothesis (EMH)15MARKET EFFICIENCY•THE EFFICIENT MARKET MODEL:–Assumptions:•costless access to available information•capable analysis skills by participants•close attention to market prices which adjust appropriately16MARKET 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 times17MARKET EFFICIENCYTHE EFFI CIENT MARKETMODELall informationinsiderinformationpublic informationTHE FAMA MARKET MODEL•THE FAMA MARKET MODEL (EQUATION)    tjttjttjprEpE,1,1,|1| 19THE 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 (20THE FAMA MARKET MODEL•E(rj,t+1) is determined by •the information set available to investors at the start of period21THE FAMA MARKET MODEL•Implication:•if markets are perfectly efficient, investors cannot earn abnormal returns based on the information set becausewhere xj,t+1 is the difference in price at t+1 between what is the price and what investors expect ttjtjtjpEpx |1,1,1,22THE FAMA MARKET MODEL–Implication:•In an efficient market•there will be no expected under- or overvaluation of securities based on the available information set 0|1, ttjxE23THE FAMA MARKET MODEL•SECURITY PRICE CHANGES ARE A RANDOM WALK–What happens when new information arrives changing t ?24THE 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 opportunities25THE FAMA MARKET MODEL•SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS:–Investors will make a fair return but no more on their investments26THE FAMA MARKET MODEL•SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS:–by searching for inefficiencies, investors ensure market efficiency27THE FAMA MARKET MODEL•SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS:–publicly known investment strategies cannot generate abnormal returns28THE FAMA MARKET MODEL•SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS:–some investors will display impressive performance records29THE FAMA MARKET MODEL•SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS:–professional investors should fare no better than ordinary investors when selecting securities30THE FAMA MARKET MODEL•SUMMARY OBSERVATIONS ABOUT EFFICIENT MARKETS:–past performance is not an indicator of future