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Security Market Structures

Security Market Structures. Markets and Participants Goals of Participants Basics of Portfolio Theory. Markets and Participants Overview . Describe interactions of buyers and sellers within a securities market Identify different market structures and mechanisms for participant interaction.

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Security Market Structures

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

  2. Markets and ParticipantsOverview • Describe interactions of buyers and sellers within a securities market • Identify different market structures and mechanisms for participant interaction FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/

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

  4. Markets and Participants • Securities Market Structure • Primary • New securities issued • Secondary • Previously issued securities • Auction vs Continuous • Central Exchange vs Over-the-Counter FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/

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

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

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

  8. Markets and ParticipantsIEM Example • NYSE Continuous - 7 hours/5 days Secondary Market Centralized Exchange • IEM Continuous - 24 hours/7 days Primary and Secondary Market Centralized Exchange FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/

  9. Markets and ParticipantsIEM Example Iowa 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 FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/

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

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

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

  13. Goals of ParticipantsOverview • Borrow or Loan (Invest) Funds • Speculate on Price Movements • Hedge • Arbitrage FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/

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

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

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

  17. Goals of Participants • Hedge (v) • To protect against risk • Hedge (n) • Purchase of a security to offset the potential loss of another security FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/

  18. Goals of ParticipantsExample: Arbitrage Iowa Electronic Markets Trader: Fred Cash: $ 4.294 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 FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/

  19. Goals of ParticipantsExample: Hedge Iowa Electronic Markets Trader: Fred Cash: $ 4.294 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 FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/

  20. Goals of ParticipantsExample: Hedge Iowa Electronic Markets Trader: Fred Cash: $ 4.294 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 FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/

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

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

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

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

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

  26. Basics of Portfolio Theory 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 FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/

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

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

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

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

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

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

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

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

  35. Summary • Markets come in many shapes and sizes • Trading strategies vary • Demand for an asset is related to return, risk, liquidity and income FALL 2000 EDITION LAST EDITED ON 9/00 WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS/

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