fall 2000 edition last edited on 9/00 1 security market structures markets and participants goals...
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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
FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/
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
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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
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Markets and Participants Markets and Participants
Securities Market Structure
– Primary New securities issued
– Secondary Previously issued securities
– Auction vs Continuous
– Central Exchange vs Over-the-Counter
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Markets and Participants Markets and Participants
Bid– Offer to buy– Quoted bid is best offer to buy
Ask– Offer to sell– Quoted ask is best offer to sell
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Markets and Participants Markets and Participants
Market Orders– Market Bid
Immediate purchase at lowest ask price
– Market Ask Immediate sale at highest bid price
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Markets and Participants Markets and Participants
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.
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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
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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
FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/
FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/
FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/
FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/
Goals of ParticipantsGoals of ParticipantsOverviewOverview Borrow or Loan (Invest) Funds Speculate on Price Movements Hedge Arbitrage
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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
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Goals of ParticipantsGoals of Participants
Some traders try to earn profits based on short-term fluctuations in securities prices
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Goals of ParticipantsGoals of Participants
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”
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Goals of ParticipantsGoals of Participants
Hedge (v)– To protect against risk
Hedge (n)– Purchase of a security to offset the potential
loss of another security
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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
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Goals of ParticipantsGoals of ParticipantsExample: HedgeExample: Hedge
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 | 1 0 0MS090bL 0.645 0.665 0.635 | 1 0 0
1. No exposureBuy both contracts, hold to payoffPayoff = $1.00 either outcome
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Goals of ParticipantsGoals of ParticipantsExample: HedgeExample: Hedge
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 | 0 0 0MS090bL 0.645 0.665 0.635 | 1 0 0
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
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Basics of Portfolio TheoryBasics of Portfolio Theory
Factors affecting asset demand– Relative return– Relative risk– Liquidity– Income
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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
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Basics of Portfolio TheoryBasics of Portfolio Theory
Risk Uncertainty of future return
Liquidity Ease and cost of selling asset for cash
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Basics of Portfolio TheoryBasics of Portfolio Theory
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%
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Basics of Portfolio TheoryBasics of Portfolio Theory
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
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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
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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?
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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
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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).
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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.
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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?
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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.
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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%
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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
FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/
SummarySummary
Markets come in many shapes and sizes Trading strategies vary Demand for an asset is related to return,
risk, liquidity and income