FALL 2000 EDITION LAST EDITED ON 9/00 1 Security Market Structures Markets and Participants Goals of Participants Basics

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

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Security Market StructuresSecurity Market StructuresMarkets and ParticipantsGoals of ParticipantsBasics of Portfolio Theory


Markets and ParticipantsMarkets and ParticipantsOverview Overview Describe interactions of buyers and sellers

within a securities market Identify different market structures and

mechanisms for participant interaction


Markets and Participants Markets and Participants

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.


Markets and ParticipantsMarkets and ParticipantsIEM ExampleIEM Example NYSE

Continuous - 7 hours/5 daysSecondary Market

Centralized Exchange

IEMContinuous - 24 hours/7 daysPrimary and Secondary MarketCentralized Exchange


Markets and ParticipantsMarkets and ParticipantsIEM ExampleIEM Example

Iowa Electronic Markets Trader: Mishkin Cash$ 4.294Iowa Electronic Markets Trader: Mishkin Cash$ 4.294 STOCK PRICE CHANGE | PORTFOLIOSTOCK PRICE CHANGE | PORTFOLIOContract Bid$ Ask$ Last$ | Holdings #Bids #AsksMS090bH 0.335 0.354 0.354 | 15 1 2MS090bL 0.635 0.665 0.635 | 12 1 2

The “market” consists of all traders with accounts on the IEM





Goals of ParticipantsGoals of ParticipantsOverviewOverview Borrow or Loan (Invest) Funds Speculate on Price Movements Hedge Arbitrage


Goals of ParticipantsGoals of Participants

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


Goals of ParticipantsGoals of ParticipantsExample: ArbitrageExample: Arbitrage

Iowa Electronic Markets Trader: Fred Cash: $ 4.294Iowa Electronic Markets Trader: Fred Cash: $ 4.294 STOCK PRICE CHANGE | PORTFOLIOSTOCK PRICE CHANGE | PORTFOLIOContract Bid$ Ask$ Last$ | Holdings #Bids #AsksMS090bH 0.315 0.325 0.354 | 15 0 0MS090bL 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


Goals of ParticipantsGoals of ParticipantsExample: HedgeExample: Hedge


1. No exposureBuy both contracts, hold to payoffPayoff = $1.00 either outcome


Goals of ParticipantsGoals of ParticipantsExample: HedgeExample: Hedge


2. Exposure - holdings 1 MS090bLPayoff if low = $1.00Payoff if high = $0

Hedge by purchasing 1 MS090bH for $0.325Payoff if low = $0.675Payoff if high = $0.675


Basics of Portfolio TheoryBasics of Portfolio Theory

Factors affecting asset demand– Relative return– Relative risk– Liquidity– Income


Basics of Portfolio TheoryBasics of Portfolio TheoryBasic CalculationsBasic 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/

compdata/compfund.html

AAPL IBM MSFT SP500 T-BillsAverage 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


Basics of Portfolio TheoryBasics of Portfolio Theory Evaluating Uncertain Returns 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


Basics of Portfolio TheoryBasics of Portfolio Theory Evaluating Uncertain Returns 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?


Basics of Portfolio TheoryBasics of Portfolio Theory Evaluating Uncertain Returns 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


Basics of Portfolio TheoryBasics of Portfolio Theory Evaluating Uncertain Returns 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).


Basics of Portfolio TheoryBasics of Portfolio Theory Evaluating Uncertain Returns 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.


Basics of Portfolio TheoryBasics of Portfolio Theory Evaluating Uncertain Returns Evaluating Uncertain Returns Suppose two assets with same expected value of

$25– Asset 1 pays

$50 with probability 1/2 $0 with probability 1/2

– Asset 2 pays $30 with probability 1/2 $20 with probability 1/2

Which would you prefer? Which is more risky?


Basics of Portfolio TheoryBasics of Portfolio Theory Evaluating Uncertain Returns Evaluating Uncertain Returns Risk concerns the variation in outcomes. Demand for assets decreases with risk.


Basics of Portfolio TheoryBasics of Portfolio Theory Evaluating Uncertain Returns 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-BillsAverage 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 Monthly Returns for Apple and IBM, Jan. 1997 to Oct. 1999IBM, 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


SummarySummary

Markets come in many shapes and sizes Trading strategies vary Demand for an asset is related to return,

risk, liquidity and income

Documents

FALL 2000 EDITION LAST EDITED ON 9/00 1 Security Market Structures Markets and Participants Goals of Participants Basics