Security Market Structures
Markets and Participants
Goals of Participants
Basics of Portfolio Theory
1
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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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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

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

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

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

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 Participants
IEM Example

NYSE
Continuous - 7 hours/5 days
Secondary Market
Centralized Exchange

IEM
Continuous - 24 hours/7 days
Primary and Secondary Market
Centralized Exchange
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Markets and Participants
IEM Example
Iowa Electronic Markets
STOCK PRICE CHANGE
Contract
Bid$
Ask$
MS090bH
0.335
0.354
MS090bL
0.635
0.665
Trader: Mishkin Cash$ 4.294
|
PORTFOLIO
Last$ | Holdings
#Bids
#Asks
0.354 |
15
1
2
0.635 |
12
1
2
The “market” consists of all traders with
accounts on the IEM
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Goals of Participants
Overview




Borrow or Loan (Invest) Funds
Speculate on Price Movements
Hedge
Arbitrage
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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
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Goals of Participants

Some traders try to earn profits based
on short-term fluctuations in securities
prices
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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”
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Goals 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 Participants
Example: Arbitrage
Iowa Electronic Markets
STOCK PRICE CHANGE
Contract
Bid$
Ask$
MS090bH
0.315
0.325
MS090bL
0.645
0.665
Trader: Fred Cash: $ 4.294
|
PORTFOLIO
Last$ | Holdings
#Bids
#Asks
0.354 |
15
0
0
0.635 |
12
0
0
1.
Purchase both contracts at market (ask
prices of $0.325 + $0.665 = $0.99)
2.
Sell bundle for $1.00
3.
Purchases will drive up price
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Goals of Participants
Example: Hedge
Iowa Electronic Markets
STOCK PRICE CHANGE
Contract
Bid$
Ask$
MS090bH
0.315
0.325
MS090bL
0.645
0.665
1.
Trader: Fred Cash: $ 4.294
|
PORTFOLIO
Last$ | Holdings
#Bids
#Asks
0.354 |
1
0
0
0.635 |
1
0
0
No exposure
Buy both contracts, hold to payoff
Payoff = $1.00 either outcome
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Goals of Participants
Example: Hedge
Iowa Electronic Markets
STOCK PRICE CHANGE
Contract
Bid$
Ask$
MS090bH
0.315
0.325
MS090bL
0.645
0.665
2.
Trader: Fred Cash: $ 4.294
|
PORTFOLIO
Last$ | Holdings
#Bids
#Asks
0.354 |
0
0
0
0.635 |
1
0
0
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
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Basics of Portfolio Theory

Factors affecting asset demand
–
–
–
–
Relative return
Relative risk
Liquidity
Income
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Basics of Portfolio Theory
Basic Calculations

Capital Gain


Percentage Change (%)


Selling price (V1) less purchase price (V0)
[(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 Theory

Risk


Uncertainty of future return
Liquidity

Ease and cost of selling asset for cash
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Basics of Portfolio Theory

Relative Return
– http://www.biz.uiowa.edu/iem/markets/compd
ata/compfund.html
Average Return
Std. Dev
AAPL
2.42%
14.84%
IBM
3.64%
10.31%
MSFT
SP500 T-Bills
4.72%
1.75%
0.35%
8.22%
3.82%
0.06%
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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
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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

FALL 2000
Probabilities of outcomes
– win $100 - 1/100
– win $0
- 99/100
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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?
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
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
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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).
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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.
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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?
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2000 EDITIONis
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EDITED ON
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 Which
more
risky?

Basics of Portfolio Theory
Evaluating Uncertain Returns


Risk concerns the variation in outcomes.
Demand for assets decreases with risk.
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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
Average Return
Std. Dev
AAPL
IBM
MSFT SP500 T-Bills
2.42% 3.64% 4.72% 1.75% 0.35%
14.84% 10.31% 8.22% 3.82% 0.06%
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Monthly Returns for Apple and
IBM, Jan. 1997 to Oct. 1999
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
-10.00%
-20.00%
-30.00%
-40.00%
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Apple
IBM
Summary



Markets come in many shapes and sizes
Trading strategies vary
Demand for an asset is related to return,
risk, liquidity and income
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