© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Chapter 3 Price Forecasting

© 2007 Thomson Delmar Learning, a part of the Thomson Corporation

Chapter 3Chapter 3

Price ForecastingPrice Forecasting


The Two Big Mine FieldsThe Two Big Mine Fields

Traders believe either that prices can be forecast or that Traders believe either that prices can be forecast or that they cannot.they cannot.

““Had a blow up” or “blew up” signify traders who have Had a blow up” or “blew up” signify traders who have lost more than they can stand.lost more than they can stand.

The The Efficient Market HypothesisEfficient Market Hypothesis (EMH) is for those (EMH) is for those who believe prices cannot be forecasted.who believe prices cannot be forecasted.– Because mine fields are randomly distributed, a certain Because mine fields are randomly distributed, a certain

number will emerge and others will blow up.number will emerge and others will blow up. The The Inefficient Market HypothesisInefficient Market Hypothesis (IMH) is for those (IMH) is for those

who believe prices can be forecasted.who believe prices can be forecasted.– Individual mine locations may be unknown, but patterns and Individual mine locations may be unknown, but patterns and

certain causes and effects can be known.certain causes and effects can be known.


Efficient Market HypothesisEfficient Market Hypothesis

Random Walk Hypothesis (RWH)Random Walk Hypothesis (RWH) EMH codified into three major forms:EMH codified into three major forms:

– Weak Form—All past information is reflected in Weak Form—All past information is reflected in price discovery.price discovery.

– Semi-Strong Form—All past information as well as Semi-Strong Form—All past information as well as all current information is used to formulate prices.all current information is used to formulate prices.

– Strong Form—All past and current information plus Strong Form—All past and current information plus all knowable information is considered in the pricing all knowable information is considered in the pricing process.process.


Inefficient Market HypothesisInefficient Market Hypothesis

IMH theorizes that market prices are not determined IMH theorizes that market prices are not determined with perfect information; prices are constantly evolving with perfect information; prices are constantly evolving as more information becomes available.as more information becomes available.

Technical analysisTechnical analysis is based on the belief that where the is based on the belief that where the market has been in the past is the best indicator of market has been in the past is the best indicator of where it will be in the future.where it will be in the future.

Fundamental analysisFundamental analysis holds that price determination holds that price determination has a cause-and-effect relationship; once the cause is has a cause-and-effect relationship; once the cause is identified, the effects can be forecast.identified, the effects can be forecast.

Identified-Insider Traders—another form of IMH?Identified-Insider Traders—another form of IMH?


Using the Efficient Market HypothesisUsing the Efficient Market Hypothesis

EMH is most commonly used in equity markets.EMH is most commonly used in equity markets. Next Day Pricing assumes that tomorrow’s price will be Next Day Pricing assumes that tomorrow’s price will be

different than today’s.different than today’s. Short Run Minimum/Maximum Prices—where the Short Run Minimum/Maximum Prices—where the

market has made a new high or low in the short run is a market has made a new high or low in the short run is a better guide for short run minimum and maximum price better guide for short run minimum and maximum price forecasts.forecasts.

EMH believers use past short-run price movements EMH believers use past short-run price movements only as a guide for general price level expectations.only as a guide for general price level expectations.

(continued)(continued)


Using the Inefficient Market HypothesisUsing the Inefficient Market Hypothesis(continued)(continued)

IMH has little appeal to the general trading IMH has little appeal to the general trading population.population.

IMH appeals primarily to academic researchers.IMH appeals primarily to academic researchers.


Fundamental Price Forecasting: Fundamental Price Forecasting: Supply and Demand Supply and Demand

Economic theory concerns how the interaction between supply Economic theory concerns how the interaction between supply and demand determines price.and demand determines price.

SupplySupply– Producer’s supply curve is upward sloping portion of his or her marginal 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 cost curve; the market supply curve will be the horizontal summation of all individual cost curves.all individual cost curves.

– Price elasticity of supply—equal to the percentage change in quantity Price elasticity of supply—equal to the percentage change in quantity supplied due to a percentage change in price.supplied due to a percentage change in price.

Fundamental price forecasters will concentrate on changes in Fundamental price forecasters will concentrate on changes in production technology, changes in the price of major inputs, and production technology, changes in the price of major inputs, and changes in the number of producers.changes in the number of producers.



Fundamental Price Forecasting: Fundamental Price Forecasting: Supply and Demand Supply and Demand (continued)(continued)

Demand curves are derived from the consumers’ utility of a Demand curves are derived from the consumers’ utility of a product—called Diminishing Marginal Utility.product—called Diminishing Marginal Utility.

Price elasticity of demandPrice elasticity of demand– is the responsiveness of quantity changes to changes in price.is the responsiveness of quantity changes to changes in price.– is equal to the percent change in the quantity demanded due is equal to the percent change in the quantity demanded due

to a present change in price.to a present change in price. The individual’s demand curve is determined by holding The individual’s demand curve is determined by holding

income, tastes and preferences, and the prices of other income, tastes and preferences, and the prices of other goods constant. goods constant.

The sum of all individual demands creates the market The sum of all individual demands creates the market demand.demand.



Fundamental Price Forecasting: Fundamental Price Forecasting: Supply and Demand Supply and Demand (continued)(continued)

Price changes cause a change in quantity demanded, and the Price changes cause a change in quantity demanded, and the amount and the availability of substitutes will determine amount and the availability of substitutes will determine how responsive the change in quantity demanded will be.how responsive the change in quantity demanded will be.

Cross price elasticity of demand is the relationship between Cross price elasticity of demand is the relationship between the price change of one commodity and the effect on the price change of one commodity and the effect on quantity demanded of another product.quantity demanded of another product.

Substitutes—an increase in the price of one product induces Substitutes—an increase in the price of one product induces an increase in the quantity demanded of another product.an increase in the quantity demanded of another product.

Complements—an increase in the price of one product Complements—an increase in the price of one product results in a negative change in the quantity demanded of results in a negative change in the quantity demanded of another product.another product.


Putting Supply and Demand TogetherPutting Supply and Demand Together

Perfect Market ModelPerfect Market Model Perfectly competitive market is a marketplace with many Perfectly competitive market is a marketplace with many

buyers and sellers who are not large enough to have any buyers and sellers who are not large enough to have any undue influence, vying for a homogenous product.undue influence, vying for a homogenous product.

A workably competitive market may be a market with A workably competitive market may be a market with many buyers and few sellers or vice versa. However, if many buyers and few sellers or vice versa. However, if neither buyers nor sellers can exert any type of monopoly neither buyers nor sellers can exert any type of monopoly power, the results are similar to a perfect market.power, the results are similar to a perfect market.

All markets are composed of many different traders and All markets are composed of many different traders and different factors.different factors.



Perfect Market Model Perfect Market Model (continued)(continued)

ArbitrageArbitrage is the process of capturing excess economic is the process of capturing excess economic profits between two or more markets. Traders who do this profits between two or more markets. Traders who do this are known as aare known as arbitragersrbitragers..

Arbitragers take advantage of the following market Arbitragers take advantage of the following market differences:differences:– Markets that are separated by space have Markets that are separated by space have spatialspatial price price

differences. Perfect spatial markets differ by the cost of differences. Perfect spatial markets differ by the cost of transportation.transportation.

TemporalTemporal markets differ by time. They should differ by markets differ by time. They should differ by the cost of storage.the cost of storage.

FormForm markets differ by the cost of processing.markets differ by the cost of processing.(continued)(continued)


Perfect Market Model Perfect Market Model (continued)(continued)

In In perfect marketsperfect markets, spatial, temporal, and form markets differ by , spatial, temporal, and form markets differ by the costs of transportation, storage, or processing—no more, no the costs of transportation, storage, or processing—no more, no less—and no excess economic profit exists.less—and no excess economic profit exists.

In In imperfect marketsimperfect markets, markets have potential profits in them , markets have potential profits in them because the price differences between the markets are larger than because the price differences between the markets are larger than the costs of transportation, storage, or processing, and arbitragers the costs of transportation, storage, or processing, and arbitragers will exploit the excess profit away.will exploit the excess profit away.

In In not perfect marketsnot perfect markets, markets price differences are less than the , markets price differences are less than the cost of transportation, storage, or processing.cost of transportation, storage, or processing.

Arbitragers will keep spatial, temporal and form markets closely Arbitragers will keep spatial, temporal and form markets closely tied together. These actions by arbitragers cause derivative tied together. These actions by arbitragers cause derivative market prices and cash market prices to market prices and cash market prices to “tend to trend “tend to trend together.”together.”


The Law of One PriceThe Law of One Price

If the difference between two or more prices can If the difference between two or more prices can be justified by cost, then the two prices are be justified by cost, then the two prices are identical except for defensible costs.identical except for defensible costs.

The law of one price is simply another way of The law of one price is simply another way of looking at the perfect market model.looking at the perfect market model.

It provides a starting point for arbitragers.It provides a starting point for arbitragers.


Artificial Price FloorsArtificial Price Floors

Artificial price floors are implemented by the Artificial price floors are implemented by the government to change supply.government to change supply.

If an artificial price is set above the market If an artificial price is set above the market equilibrium, a surplus will result (Figure 3-11).equilibrium, a surplus will result (Figure 3-11).

If an artificial price is set below the market If an artificial price is set below the market equilibrium, a shortage will result (Figure 3-12).equilibrium, a shortage will result (Figure 3-12).


Price MovementsPrice Movements

Most price movements are caused by a change Most price movements are caused by a change in either supply or demand, rarely both.in either supply or demand, rarely both.– If the majority of a price movement is caused by a If the majority of a price movement is caused by a

change in supply, it is supply driven.change in supply, it is supply driven.– If the majority of the price movement is caused by a If the majority of the price movement is caused by a

change in demand, it is demand driven.change in demand, it is demand driven. Supply Driven—see Figure 3-13.Supply Driven—see Figure 3-13. Demand Driven—see Figure 3-14.Demand Driven—see Figure 3-14.



Price Movements Price Movements (continued)(continued)

Seasonal and Cyclic MovementsSeasonal and Cyclic Movements– Agricultural commodities have biological Agricultural commodities have biological

characteristics that affect the production process.characteristics that affect the production process.– Seasonal movements are price activities that occur Seasonal movements are price activities that occur

within a calendar year or production period.within a calendar year or production period.– Cyclic movements are price tendencies that occur Cyclic movements are price tendencies that occur

over several production periods or years.over several production periods or years.


Price ForecastersPrice Forecasters

Two major types of price forecasters:Two major types of price forecasters:– ““gut” analystsgut” analysts– econometric analystseconometric analysts

Gut analystsGut analysts– filter all of the various supply and demand shifters filter all of the various supply and demand shifters

through their brain to come up with a price estimate. through their brain to come up with a price estimate. Their forecasts are based on experience, judgment, Their forecasts are based on experience, judgment, and intuition.and intuition.

– have short-lived careers when they are bad at what have short-lived careers when they are bad at what they do.they do.


EconometricsEconometrics

Econometrics is the study of quantifying economic Econometrics is the study of quantifying economic relationships.relationships.

This process involves the following:This process involves the following:– Determine the economic relationship.Determine the economic relationship.

– Determine the mathematical expression of the economic Determine the mathematical expression of the economic model.model.

– Determine what data to use and the time frame of analysisDetermine what data to use and the time frame of analysis Econometrics is far more complex than these three Econometrics is far more complex than these three

steps; however, these areas are the crux of each steps; however, these areas are the crux of each analysis.analysis.


Technical Price AnalysisTechnical Price Analysis

Technical analysis is based on the belief that Technical analysis is based on the belief that where prices have been in the past can be used where prices have been in the past can be used as a guide for the future direction.as a guide for the future direction.

The technical analystThe technical analyst– believes that all information is embedded in the price believes that all information is embedded in the price

movement and that it is impossible to fully determine movement and that it is impossible to fully determine all the factors influencing price.all the factors influencing price.

– studies the effect of fundamental analysis.studies the effect of fundamental analysis.


Types of Technical AnalysisTypes of Technical AnalysisChartingCharting

There are two types of technical analysis: charting and There are two types of technical analysis: charting and mathematical modeling.mathematical modeling.

Charting analysis: visualizes price information.Charting analysis: visualizes price information.– Chart types:Chart types:

single price chartssingle price charts bar chartsbar charts point and figure chartspoint and figure charts candlestickscandlesticks

– The purpose of each charting tool is to express visually what The purpose of each charting tool is to express visually what a price movement looks like in order to determinea price movement looks like in order to determine

how long a trend will continue.how long a trend will continue. when a trend will reverse.when a trend will reverse.


Types of Technical AnalysisTypes of Technical AnalysisMathematical ModelingMathematical Modeling

Three major categories of mathematical (or Three major categories of mathematical (or mechanical) modeling:mechanical) modeling:– Curve fitting—for a given set of past price Curve fitting—for a given set of past price

movements, an equation will be selected that best movements, an equation will be selected that best fits the data.fits the data.

– Moving averages—at least two averages of past Moving averages—at least two averages of past prices (one short-term, one longer-term) are prices (one short-term, one longer-term) are calculated; their intersection indicates a change in calculated; their intersection indicates a change in trend.trend.

– Oscillators—elementary arithmetic expressions used Oscillators—elementary arithmetic expressions used to measure the rate of change of prices.to measure the rate of change of prices.

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© 2007 Thomson Delmar Learning, a part of the Thomson Corporation Chapter 3 Price Forecasting