The Iowa Electronic Markets
Security Markets Structures
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
MSFT95bH
0.425
0.435 0.452
8
#Bids #Asks
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
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