The Iowa Electronic Markets 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. 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 exchange-traded 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, 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. 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 one-month 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. 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 TBills. (Use the Excel "average" function.) 2. Report the historical standard deviation in monthly returns for each stock, the S&P500 and T-Bills. (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. 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. 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/