The Iowa Electronic Markets
Security Markets Structures
Teaching materials using the IEM
Prepared for the Fall 1999 IEM*IDEA/FIPSE Conference
By Shannon Mudd and Cynthia Brown
November 1999
These materials were designed for use at the beginning of an undergraduate course in Money and
Banking and are consistent with the typical text descriptions of financial market structures and portfolio
theory. The materials help students understand the subject matter by engaging them in an actual
market, the Iowa Electronics Market. It assumes no previous experience with IEM markets.
Teaching Objectives
Security Markets Structures
Understand market dynamics
Students should:
1. Understand exchange within a market
2. Identify a bid as an offer from a buyer and an ask as an offer from a seller
3. Differentiate between a market and limit order2
4. List possible goals of market participants
5. Recognize the role of arbitrage in promoting efficiency
6. Understand simple portfolio theory of asset demand
Analyze demand for assets
Students should be able to:
1. Calculate realized returns
2. Chart and calculate variance
3. Relate liquidity to potential losses
4. Link uncertainty to expected returns
Utilize analytical tools to develop trading strategy
Students will trade based on one of the following strategies:
1. Arbitrage
2. Expectations
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Important Aspects of the Assignment

Students replicate analysis from the lecture.
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Available Materials
1. Lecture Outline
2. Introduction to IEM Lecture Notes
3. Student Assignment::
Finding and Computing Returns and Evaluating Risk
4. Examination Questions
5. Internet Resources
6. Power Point Slides (with lecture notes attached)
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Lecture Outline
Security Markets Structures
1. Introduction
2. Define markets and participants
a. Market organizations
b. Trading mechanisms
c. Example: IEM Market
3. Goals of participants
4. Basics of portfolio theory
a. Relative return
b. Relative risk
c. Liquidity
5. Uncertainty and expected value
6. Summary
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Security Markets Structures
Introduction to the IEM
The Iowa Electronic Market (IEM for short) is a computerized market on which financial contracts can
be traded (bought or sold). For this assignment, we will be using a series of contracts based on three
popular companies, Apple Computers (AAPL), IBM (IBM) and Microsoft (MSFT), and an important
index called the S&P500 index. Shares of the firms trade over the counter (NASDAQ) and on the New
York Stock Exchange (NYSE). Similarly, a daily index value is determined for the S&P500 based upon
the stock prices of the 500 companies that comprise it.
These contracts are listed on the IEM under the market label “Computer Industry Returns Market” or
“Comp_Ret” for short. These contracts are described briefly later in this note and in more depth in the
IEM Trader’s Manual. Detailed descriptions of these markets are available at the IEM website:
http://www.biz.uiowa.edu/iem/markets/computer.html
Objectives
The objectives of the IEM assignments are to help you apply class concepts in a "real world,"
unstructured way to learn how to:
1. Apply the CAPM to determine expected stock returns
2. Evaluate actual stock performance
3. Implement investment /trading strategies
Opening an IEM Account
All students need to open an account with the Iowa Electronic Market. This involves a minimum deposit
of ____ dollars. Funds remaining in your account are refundable at the end of the semester.
You can open an IEM account over the internet. To do so, go to the sign-up webpage:
http://iemweb.biz.uiowa.edu/signup/
and follow the instructions given to you by your instructor. (DO NOT use forms other than those given
to you by your instructor. Using other forms may result in fees or decreased deposits in your account.)
After filling out your signup forms, you may need to deposit cash with the IEM office. Your instructor will
give you details about any deposits you need to make.
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Accessing the IEM
You can access the IEM through its website address:
http://www.biz.uiowa.edu/iem/
The IEM market has several contracts for trading. The contracts of interest for our course are the
Computer Industry Returns Market (Comp_Ret, for short).
You may access your trading account from the market pages or directly at:
http://iemweb.biz.uiowa.edu/
Computer Industry Returns Contracts
The Computer Industry Returns Contracts consist of a series of contracts. Every month, existing
contracts in the series are liquidated and payments are made as described below. Then, new
contracts are created as described below. These events occur on the Monday after the exchangetraded options for the underlying stocks expire (the Monday after the third Friday of each month).
The liquidation values for the contracts in this market are determined solely by the rates of return of
Apple Computers Common Stock (AAPL), IBM Common Stock (IBM), Microsoft Common Stock
(MSFT) and the S&P500 index (SP500). Whichever of these has the highest rate of return as specified
below will payoff $1.00 per share. The remaining contracts will payoff zero. Thus, to do well in this
market, you will need to understand what determines real stock market returns.
Contracts will be designated by a ticker symbol and a letter denoting the month of contract liquidation.
Thus, the contracts traded in this market for liquidation in month “m” are:
Code
AAPLm
IBMm
MSFTm
SP500m
Underlying Asset
Apple Computers
IBM
Microsoft
S&P 500 Market Index
Liquidation Value
$1.00 if AAPL Return Highest
$1.00 if IBM Return Highest
$1.00 if MSFT Return Highest
$1.00 if SP500 Return Highest
In these contract codes, “m” refers to the month of expiration as given by the following table:
Month
January
February
March
April
Designation
a
b
c
d
Month
May
June
July
August
Designation
e
f
g
h
Month
September
October
November
December
Designation
i
j
k
l
For AAPLm, IBMm and MSFTm, the dividend-adjusted rate of return is computed based on closing
stock prices of the underlying listed firm between the third Friday in the liquidation month and the third
Friday in the previous month. For these purposes, closing prices as reported in the Midwest edition of
the Wall Street Journal are used. In particular, this return is calculated as follows. First, the raw return
on the underlying stock is computed (as the closing price on the third Friday of the liquidation month,
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minus the closing price from the third Friday of the previous month, plus any dividends on ex-dividend
dates). Then, we divide the raw return by the closing stock price from the previous month to arrive at
the dividend-adjusted rate of return.
For the SP500 contract, the return is computed as the capital gains rate of return. To do this, subtract
the closing index value on the third Friday of the previous month from the closing index value on the
third Friday of the liquidation month. Then, divide by the previous month’s closing index value.
Trading on the IEM
You can trade on the IEM in several ways. First, you can buy or sell unit portfolios. A unit portfolio is a
set of contracts such as AAPLm, IBMm, MSFTm and SP500m. You can always buy or sell such
portfolios for $1.00 each. Thus, when you start to trade and do not own any contracts, you can buy a
unit portfolio and then start to trade. (To do this, select the appropriate contract under “Buy Bundles” or
“Sell Bundles” in the “Market Order” drop down menu. Enter a quantity and press the “Market Order”
button.)
Second, you can buy or sell using a "market order." On the market screen, you will see that some
individuals have posted an order to buy or to sell a contract (e.g., MSFTi, the contract for September
liquidation in the Computer Industry Returns Market) at a specific price. If you believe that a posted
order represents a good deal, you can buy or sell at the posted price. (To do this, select the
appropriate contract under “Buy at Best Ask” or “Sell at Best Bid” in the “Market Order” drop down
menu. Enter a quantity and press the “Market Order” button.)
Third, you can buy or sell using a "limit order." To do so, you state the price at which you are willing to
buy or sell a contract and post a limit order on the screen. In doing so, you are waiting for someone
who is willing to buy or sell at your stated price. In this manner, when your order executes, it will
execute at your stated price, not at somebody else’s. The negative is that the order may never execute
because nobody likes your price because it is too high or low. (To place a limit order, select the
appropriate contract under “Post a Bid” or “Post an Ask” in the “Limit Order” drop down menu. Enter a
price, quantity and expiration date and press the “Limit Order” button.)
Completing Your Assignments and Submitting Them
As you can see below, the IEM assignments are extensive, multi-part assignments that draw together
many concepts from the class. It would be wise to work on the various parts of the assignments as we
go over the relevant topics in class. To prepare the assignments for submission, please use the
following guidelines:
1. Each assignment must be typed. Label clearly each assignment with a cover page giving
your name, student number, and section number.
2. Complete each part in a separate section clearly labeling them Part 1, Part 2, etc.
3. Within each section, give the requested information, including sources of information
gathered and equations used to calculate results.
4. Turn in your completed assignment to your instructor on the date it is due.
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Security Markets Structures Assignment
Finding and Computing Returns and Evaluating Risk
DUE: ___________
GOAL
In this assignment, you will learn where to find current and historical prices and how to use them to
compute returns and risk and develop strategies for trading.
Current stock returns
The IEM Computer Industry Returns or MSFT (Microsoft) Price Level markets depend upon the
following three stocks: AAPL, IBM, MSFT and the S&P500 index. The prices of these stocks and the
value of the S&P500 index are reported in the Wall Street Journal and in various places on-line (e.g.,
http://quote.yahoo.com).
Starting on the third Friday of ____________, record the closing prices each Friday for AAPL, IBM,
MSFT and the S&P500 index. (If you use a print source such as the Wall Street Journal, notice that,
typically, these prices will appear in the following Monday’s edition.) Continue recording prices each
Friday through the third Friday in ________. Report this information in a table labeled Table 1. (Note:
While you are free to use any source, the contracts are liquidated based on Wall Street Journal
reported prices.) In addition to gathering prices, determine whether any dividends are paid on the three
stocks AAPL, IBM and MSFT during any week. (This information is also available on the IEM website,)
For each Friday from ________ to ________, report the dividend adjusted return from the first recorded
date to the current date for each stock calculated from the prices and dividends (if any) in Table 1.
Report these returns in Table 1 as well.
Historical stock returns
Download the third Friday to third Friday stock returns for AAPL, IBM, MSFT, the S&P500 and onemonth Treasury Bills from the IEM website at:
http://www.biz.uiowa.edu/iem/markets/compdata/compfund.html
You will use these returns in later parts of this exercise.
Now collect monthly historical data on securities in order to directly calculate returns and risk.
Download 1 year worth of monthly stock prices and dividends from Yahoo's website as follows.
1.
2.
3.
4.
Go to : http://quote.yahoo.com
Enter AAPL as the ticker symbol and press the "get quote" button.
Select the "Chart" link.
At the bottom of the chart, select the "monthly" tables link.
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5. Select the appropriate dates in the resulting table and press the "get historical data" button
with the "Monthly" radio button selected.
6. At the bottom of the table, select the "download spreadsheet format" link.
7. Save the resulting "csv" format file. You can load this into Excel for analysis.
8. Select the "Dividend" radio button and press the "get historical data" button again to
download dividends.
Repeat this procedure for AAPL, IBM, MSFT and the S&P500 (ticker symbol ^spx). You can also
download 3 month T-Bill rates using the ticker symbol "^irx". The T-Bill data is in the form of return
each month.
For each stock, for the third Friday of each month, use Excel to compute the dividend adjusted return
from the third Friday of the previous month. Also, compute the returns to the S&P500 for the same
periods. (It may be easier to delete intervening days and keep only the data from the third Friday of
each month).
This data is also available from the IEM website at
http://www.biz.uiowa.edu/iem/markets/compdata/compfund.html
You can compare your calculations with these. In addition, download the returns for T-bills over the
same period from this site.
Risk Analysis
Analyze the calculated monthly returns by reporting the following information (all numbers can be
computed in Excel):
1. Report the historical average monthly return for each stock, the S&P500 index and T-Bills.
(Use the Excel "average" function.)
2. Report the historical standard deviation in monthly returns for each stock, the S&P500 and TBills. (Use the Excel "stdev" function.)
Which security had the highest average returns over the period?
Which security was the most risky?
Returns to IEM Contracts
Although past performance is no guarantee of future performance, combined with current information
on the prospects for these securities you may form your own prediction of which stock will have the
highest return over the current period. How much are you willing to pay for a security that would pay $1
if your prediction were correct? What determines your willingness to pay?
An alternative way to profit from trading is to look for arbitrage opportunities rather than trade based on
your expectations of future payoffs. Describe a potential opportunity to make a profit with zero risk using
the IEM market.
Make at least one trade in the IEM Computer Industry Returns market between the ________ and
________. Choose one trade to use for the rest of this part.
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Report the date of the trade, the contract traded and the price. Attach a print out showing your trading
activity. (You can either submit a “Processed Orders” report or an ‘Order History” report. To get the
first report, make sure that the “confirm” box is checked on the trading screen. You will be asked to
“execute” the order. Upon execution, the “Processed Orders” report will appear. To get the second
report, go to “My Account” information select “view order history” and print the resulting report.)
Based on the date of your trade, what is the holding period (in days) to the contract buyer if each
contract is held to its liquidation date?
Calculate and report the return over this holding period to the contract buyer if the contract liquidates for
$1.
Also calculate and report the return over the holding period to the contract buyer if the contract
liquidates for $0.
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Examination Questions
1. Give an example of how the primary securities market channels funds from savers to borrowers.
The primary securities market is where new issues of a security are first sold to
buyers by the entity borrowing the funds. An example is the issuance of common
stock and its purchase by investors.
2. What role does the secondary market play in financial intermediation?
Previously issued securities are bought and sold in the secondary market. The price
determined in the secondary market sets the price in the primary market. The
secondary market provides liquidity making the securities more desirable.
3. What is the difference between a ‘bid’ and ‘ask’ price in securities markets?
A bid price is how much a buyer is willing to pay to buy a security.
An ask price is how much a seller is willing to accept to sell a security.
4. If the IEM shows a Bid$ of 0.335 and a Ask$ of 0.354 and you wish to buy a contract at
the market price, how much will you pay for the contract?
You will pay $0.354.
5. How does an investor benefit from arbitrage?
Arbitrage allows an investor to profit from a price differential between two securities
with the same stream of payoffs.
6. Are arbitrage opportunities readily available in the marketplace? Why or why not?
Arbitrage opportunities are not readily available because trading on price differentials
between two securities will force the prices together thus removing the arbitrage
opportunity.
7. Suppose that an investor currently holds the following IEM portfolio. Does an arbitrage
opportunity exist? Why or why not?
Contract
Bid$
Ask$
Last$
Holdings
#Bids #Asks
MSFT95bH
0.425
0.435 0.452
8
0
0
MSFT95bL
0.540
0.555 0.535
5
0
0
An arbitrage opportunity exists since an investor can buy one contract each of MSFT
H and L for less than $1.00 (0.435 + 0.555 = 0.99). Then these contracts can be
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resold to IEM as a bundle for $1.00. This generates a no risk profit of $0.01 for the
transaction.
8. How does an investor use a hedge to protect against risk?
An investor can purchase a security that will produce a gain when another security
produces a loss. This allows for a less uncertain return and thus reduces risk.
9. Suppose that an investor currently holds the following portfolio. What is the expected
return if the probability of the MSFT high is 50%? What would be the expected return if
you fully hedged this contract?
Contract
Bid$
Ask$
Last$
Holdings
#Bids #Asks
MSFT95bH
0.550
0.565 0.545
1
0
0
MSFT95bL
0.425
0.435 0.452
0
0
0
(1) Expected return =(0.50 x 1.00) + (0.50 x 0) = $0.50
(2) Exposure = 1 holding of MSFT95bH
Payoff if high = $1.00; Payoff if low = $0
Hedge by purchasing 1 MSFT95BL for $0.435
Payoff if high = (1.00 – 0.435) = $0.57; Payoff if low = (1.00 – 0.435) = $0.57
Expected return = (0.50 x 0.57) + (0.50 x 0.57) = $0.57
10. What is the return on a security that is purchased for $150 and sold for $175?
Return = (175-150)/150 x 100 = 17%
11. What is the return on a security that is purchased for $65, earns a dividend of $2, and
sold for $68?
Return = [(68-65)/65 + 2/65] x 100 = 8%
12. Rank the following assets with the most liquid being ‘1’.
_____ Original manuscript of a finance text inherited from Aunt Minnie
_____ Share of Microsoft common stock (NASDAQ listed)
_____ Checking account
_____ Share of Dare You, Inc. (not exchange listed)
4, 2, 1, 3
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Internet Resources
IEM Home Page:
http://www.biz.uiowa.edu/iem
Stock prices and dividends: http://quote.yahoo.com
Historical data for computer returns industry:
http://biz.uiowa.edu/iem/markets/compdata/compfund.html
Apple Home Page:
http://www.apple.com/
IBM Home Page:
http://www.ibm.com/
Microsoft Home Page:
http://www.microsoft.com/
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Security Markets Structures
Power Point Presentation and Class Notes
(see separate file)
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