1. FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/ 1 Security Market Structures Markets and Participants Goals of Participants Basics of Portfolio Theory

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

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

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

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

6. FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/ Markets and Participants l Market Orders –Market Bid l Immediate purchase at lowest ask price –Market Ask l Immediate sale at highest bid price

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

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

9. FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/ Markets and Participants IEM Example Iowa Electronic Markets Trader: Mishkin Cash$ 4.294 STOCK PRICE CHANGE | PORTFOLIO 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

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

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

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

15. FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/ Goals of Participants l Some traders try to earn profits based on short-term fluctuations in securities prices

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

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

18. FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/ Goals of Participants Example: Arbitrage Iowa Electronic Markets Trader: Fred Cash: $ 4.294 STOCK PRICE CHANGE | PORTFOLIO STOCK PRICE CHANGE | PORTFOLIO Contract Bid$ Ask$ Last$ | Holdings #Bids #Asks 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

19. FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/ Goals of Participants Example: Hedge Iowa Electronic Markets Trader: Fred Cash: $ 4.294 STOCK PRICE CHANGE | PORTFOLIO STOCK PRICE CHANGE | PORTFOLIO Contract Bid$ Ask$ Last$ | Holdings #Bids #Asks 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

20. FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/ Goals of Participants Example: Hedge Iowa Electronic Markets Trader: Fred Cash: $ 4.294 STOCK PRICE CHANGE | PORTFOLIO STOCK PRICE CHANGE | PORTFOLIO Contract Bid$ Ask$ Last$ | Holdings #Bids #Asks 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

21. FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/ Basics of Portfolio Theory l Factors affecting asset demand –Relative return –Relative risk –Liquidity –Income

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

23. FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/ Basics of Portfolio Theory l Risk l Uncertainty of future return l Liquidity l Ease and cost of selling asset for cash

24. FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/ Basics of Portfolio Theory l Relative Return –http://www.biz.uiowa.edu/iem/markets/compd ata/compfund.html

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

26. FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/ 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 - 1/100 –win $0 - 99/100

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

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

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

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

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

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

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

34. FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/ Monthly Returns for Apple and IBM, Jan. 1997 to Oct. 1999

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