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FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/1

Security Market StructuresMarkets and ParticipantsGoals of ParticipantsBasics of Portfolio Theory

FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/

Markets and Participants

Overview Describe interactions of buyers and sellers

within a securities market

Identify different market structures and mechanisms for participant interaction



Security

– Claim on issuer’s future income

– Stocks vs. Bonds

Securities Market

– Group of entities trading securities

– Traditional

NYSE, CBOT, CME

– Electronic

NASDAQ, IEM



Securities Market Structure

– Primary

New securities issued

– Secondary

Previously issued securities

– Auction vs Continuous

– Central Exchange vs Over-the-Counter



Bid

– Offer to buy

– Quoted bid is best offer to buy

Ask

– Offer to sell

– Quoted ask is best offer to sell



Market Orders

– Market Bid

Immediate purchase at lowest ask price

– Market Ask

Immediate sale at highest bid price



Limit Orders

– Limit Bid

Offer to purchase security at a specified price for a

specified time period. Trade is executed only if an

equal or lower ask price is offered.

– Limit Ask

Offer to sell security at a specified price for a

specified time period. Trade is executed only if an

equal or higher bid price is offered.



IEM Example NYSE

Continuous - 7 hours/5 daysSecondary Market Centralized Exchange

IEM

Continuous - 24 hours/7 days

Primary and Secondary MarketCentralized Exchange



IEM ExampleIowa Electronic Markets Trader: Mishkin Cash$ 4.294

STOCK PRICE CHANGE | PORTFOLIO

Contract Bid$ Ask$ Last$ | Holdings #Bids #Asks

MS090bH 0.335 0.354 0.354 | 15 1 2

MS090bL 0.635 0.665 0.635 | 12 1 2

The “market” consists of all traders with

accounts on the IEM





Goals of Participants

Overview

Borrow or Loan (Invest) Funds

Speculate on Price Movements

Hedge

Arbitrage



Securities markets channel funds from lenders to borrowers

Securities markets are a source of funds for borrowers

Securities markets provide an opportunity to invest for lenders



Some traders try to earn profits based on short-term fluctuations in securities prices



Arbitrage

– Profit from price differentials from two

securities with the same stream of payoffs.

Arbitrageurs seek profits

– “Exploit” arbitrage opportunities

Arbitrageurs help force prices “into line”



Hedge (v)

– To protect against risk

Hedge (n)

– Purchase of a security to offset the potential

loss of another security



Example: ArbitrageIowa Electronic Markets Trader: Fred Cash: $ 4.294



MS090bH 0.315 0.325 0.354 | 15 0 0

MS090bL 0.645 0.665 0.635 | 12 0 0

1. Purchase both contracts at market (ask

prices of $0.325 + $0.665 = $0.99)

2. Sell bundle for $1.00

3. Purchases will drive up price



Example: HedgeIowa Electronic Markets Trader: Fred Cash: $ 4.294



MS090bH 0.315 0.325 0.354 | 1 0 0

MS090bL 0.645 0.665 0.635 | 1 0 0

1. No exposure

Buy both contracts, hold to payoff

Payoff = $1.00 either outcome



Example: HedgeIowa Electronic Markets Trader: Fred Cash: $ 4.294



MS090bH 0.315 0.325 0.354 | 0 0 0

MS090bL 0.645 0.665 0.635 | 1 0 0

2. Exposure - holdings 1 MS090bL

Payoff if low = $1.00

Payoff if high = $0

Hedge by purchasing 1 MS090bH for $0.325

Payoff if low = $0.675

Payoff if high = $0.675


Basics of Portfolio Theory

Factors affecting asset demand

– Relative return

– Relative risk

– Liquidity

– Income



Basic Calculations Capital Gain

Selling price (V1) less purchase price (V0)

Percentage Change (% ) [(V1 - V0) / V0] 100

Return Sum of capital gains and other payments (P) during

holding period as fraction of purchase price V0

[(V1 - V0) / V0 + P/ V0] 100



Risk Uncertainty of future return

Liquidity Ease and cost of selling asset for cash



Relative Return

– http://www.biz.uiowa.edu/iem/markets/compd

ata/compfund.html

AAPL IBM MSFT SP500 T-Bills

Average Return 2.42% 3.64% 4.72% 1.75% 0.35%

Std. Dev 14.84% 10.31% 8.22% 3.82% 0.06%



Liquidity

– Ease and cost of selling asset for cash

– Example: compare two assets

3-month certificate of deposit (CD)

Savings deposit held for 3 months

– The CD is less liquid because must pay a

penalty to withdraw money early



Evaluating Uncertain Returns Pool example

– 100 people each pay $1 to participate in a

pool. Each places their name in the hat. A

single name is drawn. That person receives the

pool of $100.

Possible outcomes

– win $100

– win $0

Probabilities of outcomes

– win $100 - 1/100

– win $0 - 99/100



Evaluating Uncertain Returns Pool example (continued)

– Expected Value, EV

EV = (P$100 × $100) + (P$0 × $0)

EV = (1/100 × $100) + (99/100 × $0)

EV = $1

– Fair bet EV = price

– To participate in pool, pay $1. EV of

participation = $1.

Fair bet.

Would you participate?



Evaluating Uncertain Returns Expected Value is a way to evaluate an

uncertain payoff.

How much would you be willing to pay for a 1/100 chance to win $1000?

– Expected value is $10.

How much would you be willing to pay for a 1/100 chance of winning $100,000?

– Expected value is $1,000



Evaluating Uncertain Returns Why were fewer willing to play for

$100,000 than for $100?

– Both were fair bets in that the price equaled

the expected value.

Risk Averse - weigh losses more heavily than gains.

Risk averse traders must be compensated to take on risk (pay less than expected return).



Evaluating Uncertain Returns Risk averse traders must be compensated

to take on risk.

The expected return is the expected value of uncertain returns

Because traders are risk averse, they will pay less for an asset than its expected return.



Evaluating Uncertain Returns Suppose two assets with same expected

value of $25

– Asset 1 pays

$50 with probability 1/2


– Asset 2 pays



Which would you prefer?

Which is more risky?



Evaluating Uncertain Returns Risk concerns the variation in outcomes.

Demand for assets decreases with risk.



Evaluating Uncertain Returns Standard Deviation is a measure of risk.

– Measures how close the returns are to the

expected returns.

Data are monthly returns and standard deviations

from April 1995 to October 1999

AAPL IBM MSFT SP500 T-Bills

Average Return 2.42% 3.64% 4.72% 1.75% 0.35%

Std. Dev 14.84% 10.31% 8.22% 3.82% 0.06%


Monthly Returns for Apple and

IBM, Jan. 1997 to Oct. 1999

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

Apple

IBM


Summary

Markets come in many shapes and sizes

Trading strategies vary

Demand for an asset is related to return, risk, liquidity and income

Business

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