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

FALL 2000 EDITION LAST EDITED ON 9/00 Markets and Participants Overview l Describe interactions of buyers and sellers within a securities market l Identify different market structures and mechanisms for participant interaction

FALL 2000 EDITION LAST EDITED ON 9/00 Markets and Participants l Security –Claim on issuer’s future income –Stocks vs. Bonds l Securities Market –Group of entities trading securities –Traditional l NYSE, CBOT, CME –Electronic l NASDAQ, IEM

FALL 2000 EDITION LAST EDITED ON 9/00 Markets and Participants l Securities Market Structure –Primary l New securities issued –Secondary l Previously issued securities –Auction vs Continuous –Central Exchange vs Over-the-Counter

FALL 2000 EDITION LAST EDITED ON 9/00 Markets and Participants l Bid –Offer to buy –Quoted bid is best offer to buy l Ask –Offer to sell –Quoted ask is best offer to sell

FALL 2000 EDITION LAST EDITED ON 9/00 Markets and Participants l Market Orders –Market Bid l Immediate purchase at lowest ask price –Market Ask l Immediate sale at highest bid price

FALL 2000 EDITION LAST EDITED ON 9/00 Markets and Participants l Limit Orders –Limit Bid l 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 l 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.

FALL 2000 EDITION LAST EDITED ON 9/00 Markets and Participants IEM Example l NYSE Continuous - 7 hours/5 days Secondary Market Centralized Exchange l IEM Continuous - 24 hours/7 days Primary and Secondary Market Centralized Exchange

FALL 2000 EDITION LAST EDITED ON 9/00 Markets and Participants IEM Example Iowa Electronic Markets Trader: Mishkin Cash$ STOCK PRICE CHANGE | PORTFOLIO STOCK PRICE CHANGE | PORTFOLIO Contract Bid$ Ask$ Last$ | Holdings #Bids #Asks MS090bH | MS090bL | The “market” consists of all traders with accounts on the IEM

FALL 2000 EDITION LAST EDITED ON 9/00

Goals of Participants Overview l Borrow or Loan (Invest) Funds l Speculate on Price Movements l Hedge l Arbitrage

FALL 2000 EDITION LAST EDITED ON 9/00 Goals of Participants l Securities markets channel funds from lenders to borrowers l Securities markets are a source of funds for borrowers l Securities markets provide an opportunity to invest for lenders

FALL 2000 EDITION LAST EDITED ON 9/00 Goals of Participants l Some traders try to earn profits based on short-term fluctuations in securities prices

FALL 2000 EDITION LAST EDITED ON 9/00 Goals of Participants l Arbitrage –Profit from price differentials from two securities with the same stream of payoffs. l Arbitrageurs seek profits –“Exploit” arbitrage opportunities l Arbitrageurs help force prices “into line”

FALL 2000 EDITION LAST EDITED ON 9/00 Goals of Participants l Hedge (v) –To protect against risk l Hedge (n) –Purchase of a security to offset the potential loss of another security

FALL 2000 EDITION LAST EDITED ON 9/00 Goals of Participants Example: Arbitrage Iowa Electronic Markets Trader: Fred Cash: $ STOCK PRICE CHANGE | PORTFOLIO STOCK PRICE CHANGE | PORTFOLIO Contract Bid$ Ask$ Last$ | Holdings #Bids #Asks MS090bH | MS090bL | Purchase both contracts at market (ask prices of $ $0.665 = $0.99) 2. Sell bundle for $ Purchases will drive up price

FALL 2000 EDITION LAST EDITED ON 9/00 Goals of Participants Example: Hedge Iowa Electronic Markets Trader: Fred Cash: $ STOCK PRICE CHANGE | PORTFOLIO STOCK PRICE CHANGE | PORTFOLIO Contract Bid$ Ask$ Last$ | Holdings #Bids #Asks MS090bH | MS090bL | No exposure Buy both contracts, hold to payoff Payoff = $1.00 either outcome

FALL 2000 EDITION LAST EDITED ON 9/00 Goals of Participants Example: Hedge Iowa Electronic Markets Trader: Fred Cash: $ STOCK PRICE CHANGE | PORTFOLIO STOCK PRICE CHANGE | PORTFOLIO Contract Bid$ Ask$ Last$ | Holdings #Bids #Asks MS090bH | MS090bL | 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

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory l Factors affecting asset demand –Relative return –Relative risk –Liquidity –Income

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory Basic Calculations l Capital Gain l Selling price (V 1 ) less purchase price (V 0 ) l Percentage Change (%  ) l [(V 1 - V 0 ) / V 0 ]  100 l Return l Sum of capital gains and other payments (P) during holding period as fraction of purchase price V 0 l [(V 1 - V 0 ) / V 0 + P/ V 0 ]  100

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory l Risk l Uncertainty of future return l Liquidity l Ease and cost of selling asset for cash

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory l Relative Return – ata/compfund.html

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory l Liquidity –Ease and cost of selling asset for cash –Example: compare two assets l 3-month certificate of deposit (CD) l Savings deposit held for 3 months –The CD is less liquid because must pay a penalty to withdraw money early

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory Evaluating Uncertain Returns l 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. l Possible outcomes –win $100 –win $0 l Probabilities of outcomes –win $ /100 –win $0 - 99/100

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory Evaluating Uncertain Returns l Pool example (continued) –Expected Value, EV l EV = (P $100 × $100) + (P $0 × $0) l EV = (1/100 × $100) + (99/100 × $0) l EV = $1 –Fair bet EV = price –To participate in pool, pay $1. EV of participation = $1. l Fair bet. l Would you participate?

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory Evaluating Uncertain Returns l Expected Value is a way to evaluate an uncertain payoff. l How much would you be willing to pay for a 1/100 chance to win $1000? –Expected value is $10. l How much would you be willing to pay for a 1/100 chance of winning $100,000? –Expected value is $1,000

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory Evaluating Uncertain Returns l Why were fewer willing to play for $100,000 than for $100? –Both were fair bets in that the price equaled the expected value. l Risk Averse - weigh losses more heavily than gains. l Risk averse traders must be compensated to take on risk (pay less than expected return).

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory Evaluating Uncertain Returns l Risk averse traders must be compensated to take on risk. l The expected return is the expected value of uncertain returns l Because traders are risk averse, they will pay less for an asset than its expected return.

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory Evaluating Uncertain Returns l Suppose two assets with same expected value of $25 –Asset 1 pays l $50 with probability 1/2 l $0 with probability 1/2 –Asset 2 pays l $30 with probability 1/2 l $20 with probability 1/2 l Which would you prefer? l Which is more risky?

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory Evaluating Uncertain Returns l Risk concerns the variation in outcomes. l Demand for assets decreases with risk.

FALL 2000 EDITION LAST EDITED ON 9/00 Basics of Portfolio Theory Evaluating Uncertain Returns l Standard Deviation is a measure of risk. –Measures how close the returns are to the expected returns. l Data are monthly returns and standard deviations from April 1995 to October 1999

FALL 2000 EDITION LAST EDITED ON 9/00 Monthly Returns for Apple and IBM, Jan to Oct. 1999

FALL 2000 EDITION LAST EDITED ON 9/00 Summary l Markets come in many shapes and sizes l Trading strategies vary l Demand for an asset is related to return, risk, liquidity and income