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Transcript
Chapter 3
Price Forecasting
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
The Two Big Mine Fields
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Traders believe either that prices can be forecast or that
they cannot.
“Had a blow up” or “blew up” signify traders who have
lost more than they can stand.
The Efficient Market Hypothesis (EMH) is for those
who believe prices cannot be forecasted.
– Because mine fields are randomly distributed, a certain
number will emerge and others will blow up.

The Inefficient Market Hypothesis (IMH) is for those
who believe prices can be forecasted.
– Individual mine locations may be unknown, but patterns and
certain causes and effects can be known.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Efficient Market Hypothesis

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Random Walk Hypothesis (RWH)
EMH codified into three major forms:
– Weak Form—All past information is reflected in
price discovery.
– Semi-Strong Form—All past information as well as
all current information is used to formulate prices.
– Strong Form—All past and current information plus
all knowable information is considered in the pricing
process.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Inefficient Market Hypothesis
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IMH theorizes that market prices are not determined
with perfect information; prices are constantly evolving
as more information becomes available.
Technical analysis is based on the belief that where the
market has been in the past is the best indicator of
where it will be in the future.
Fundamental analysis holds that price determination
has a cause-and-effect relationship; once the cause is
identified, the effects can be forecast.
Identified-Insider Traders—another form of IMH?
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Using the Efficient Market Hypothesis
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EMH is most commonly used in equity markets.
Next Day Pricing assumes that tomorrow’s price will be
different than today’s.
Short Run Minimum/Maximum Prices—where the
market has made a new high or low in the short run is a
better guide for short run minimum and maximum price
forecasts.
EMH believers use past short-run price movements
only as a guide for general price level expectations.
(continued)
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Using the Inefficient Market Hypothesis
(continued)
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IMH has little appeal to the general trading
population.
IMH appeals primarily to academic researchers.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Fundamental Price Forecasting:
Supply and Demand

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Economic theory concerns how the interaction between supply
and demand determines price.
Supply
– Producer’s supply curve is upward sloping portion of his or her marginal
cost curve; the market supply curve will be the horizontal summation of
all individual cost curves.
– Price elasticity of supply—equal to the percentage change in quantity
supplied due to a percentage change in price.

Fundamental price forecasters will concentrate on changes in
production technology, changes in the price of major inputs, and
changes in the number of producers.
(continued)
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Fundamental Price Forecasting:
Supply and Demand (continued)
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Demand curves are derived from the consumers’ utility of a
product—called Diminishing Marginal Utility.
Price elasticity of demand
– is the responsiveness of quantity changes to changes in price.
– is equal to the percent change in the quantity demanded due
to a present change in price.

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The individual’s demand curve is determined by holding
income, tastes and preferences, and the prices of other
goods constant.
The sum of all individual demands creates the market
demand.
(continued)
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Fundamental Price Forecasting:
Supply and Demand (continued)
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Price changes cause a change in quantity demanded, and the
amount and the availability of substitutes will determine
how responsive the change in quantity demanded will be.
Cross price elasticity of demand is the relationship between
the price change of one commodity and the effect on
quantity demanded of another product.
Substitutes—an increase in the price of one product induces
an increase in the quantity demanded of another product.
Complements—an increase in the price of one product
results in a negative change in the quantity demanded of
another product.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Putting Supply and Demand Together
Perfect Market Model
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Perfectly competitive market is a marketplace with many
buyers and sellers who are not large enough to have any
undue influence, vying for a homogenous product.
A workably competitive market may be a market with
many buyers and few sellers or vice versa. However, if
neither buyers nor sellers can exert any type of monopoly
power, the results are similar to a perfect market.
All markets are composed of many different traders and
different factors.
(continued)
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Perfect Market Model (continued)
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Arbitrage is the process of capturing excess economic
profits between two or more markets. Traders who do this
are known as arbitragers.
Arbitragers take advantage of the following market
differences:
– Markets that are separated by space have spatial price
differences. Perfect spatial markets differ by the cost of
transportation.
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Temporal markets differ by time. They should differ by
the cost of storage.
Form markets differ by the cost of processing.
(continued)
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Perfect Market Model (continued)
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In perfect markets, spatial, temporal, and form markets differ by
the costs of transportation, storage, or processing—no more, no
less—and no excess economic profit exists.
In imperfect markets, markets have potential profits in them
because the price differences between the markets are larger than
the costs of transportation, storage, or processing, and arbitragers
will exploit the excess profit away.
In not perfect markets, markets price differences are less than the
cost of transportation, storage, or processing.
Arbitragers will keep spatial, temporal and form markets closely
tied together. These actions by arbitragers cause derivative
market prices and cash market prices to “tend to trend
together.”
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
The Law of One Price
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If the difference between two or more prices can
be justified by cost, then the two prices are
identical except for defensible costs.
The law of one price is simply another way of
looking at the perfect market model.
It provides a starting point for arbitragers.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Artificial Price Floors
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Artificial price floors are implemented by the
government to change supply.
If an artificial price is set above the market
equilibrium, a surplus will result (Figure 3-11).
If an artificial price is set below the market
equilibrium, a shortage will result (Figure 3-12).
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Price Movements
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Most price movements are caused by a change in
either supply or demand, rarely both.
– If the majority of a price movement is caused by a
change in supply, it is supply driven.
– If the majority of the price movement is caused by a
change in demand, it is demand driven.
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Supply Driven—see Figure 3-13.
Demand Driven—see Figure 3-14.
(continued)
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Price Movements (continued)
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Seasonal and Cyclic Movements
– Agricultural commodities have biological
characteristics that affect the production process.
– Seasonal movements are price activities that occur
within a calendar year or production period.
– Cyclic movements are price tendencies that occur
over several production periods or years.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Price Forecasters

Two major types of price forecasters:
– “gut” analysts
– econometric analysts

Gut analysts
– filter all of the various supply and demand shifters
through their brain to come up with a price estimate.
Their forecasts are based on experience, judgment,
and intuition.
– have short-lived careers when they are bad at what
they do.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Econometrics
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Econometrics is the study of quantifying economic
relationships.
This process involves the following:
– Determine the economic relationship.
– Determine the mathematical expression of the economic
model.
– Determine what data to use and the time frame of analysis

Econometrics is far more complex than these three
steps; however, these areas are the crux of each
analysis.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Technical Price Analysis
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Technical analysis is based on the belief that
where prices have been in the past can be used
as a guide for the future direction.
The technical analyst
– believes that all information is embedded in the price
movement and that it is impossible to fully determine
all the factors influencing price.
– studies the effect of fundamental analysis.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Types of Technical Analysis
Charting
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There are two types of technical analysis: charting and
mathematical modeling.
Charting analysis: visualizes price information.
– Chart types:
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single price charts
bar charts
point and figure charts
candlesticks
– The purpose of each charting tool is to express visually what a
price movement looks like in order to determine


how long a trend will continue.
when a trend will reverse.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation
Types of Technical Analysis
Mathematical Modeling
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Three major categories of mathematical (or
mechanical) modeling:
– Curve fitting—for a given set of past price
movements, an equation will be selected that best
fits the data.
– Moving averages—at least two averages of past
prices (one short-term, one longer-term) are
calculated; their intersection indicates a change in
trend.
– Oscillators—elementary arithmetic expressions used
to measure the rate of change of prices.
© 2007 Thomson Delmar Learning, a part of the Thomson Corporation