Solution to Homework 1:Financial Markets

Nina Boyarchenko
Posted on: January 30, 2018

1 Financial Markets
1. Consider the following limit order book of a specialist. The last trade in
the stock took place at a price of $35.

Limit Buy Orders Limit Sell Orders

Price Shares Price Shares
$34.25 100 $35.25 800
$34.00 200 $35.50 500
$33.50 500 $36.00 1,000
$33.00 100 $36.25 400

If you were the specialist what would you want to do with your inventory
of this stock? Please explain your answer.

(a) decrease
(b) increase
(c) does not matter
(d) there is not enough information to decide

Answer to Question 1
The objective of the market maker is to keep his inventory relatively small since it
is risky. Given that the limit book has many more limit sell orders than buy orders,
this suggests that there are fewer people likely to buy going forward. Therefore, the
dealer expects that the price will drop and that he will be buying shares from all the
customers selling. The short answer is that the dealer would decrease his inventory. A
more detailed answer could include the current position of the dealer:

• If the dealer has a positive inventory it is very risky, as he expects the prices to
drop. He will decrease his inventory to lower his risk.

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 • If the dealer has close to zero inventory, he might initially try to decrease his
inventory. He expects that going forward more people will be selling, and hence
the dealer will be buying from them. To avoid ending up with a positive inventory,
he decreases his inventory now.
• If the dealer has a large negative inventory, he might view this as an opportunity
to buy back some of the shares he has sold short.

2. Suppose the debt holders of a cosmetics firm hold debt with a face value of
$500,000. The rest of the firm is owned by stockholders. The firm’s profits
will depend on the demand it will face in the market for cosmetic products.
Three cases are possible:

Case (1): If demand is very low, the firm’s profits will be $300,000.
Case (2): If the demand is at its average value, the firm’s profits will
be $500,000.
Case (3): If demand is very high, the firm’s profits will be $1,000,000.

(a) Calculate the payoffs to the debt holders and the equity holders in each
of the three cases.
(b) For each of the three cases, state whether the firm is bankrupt or
solvent.

Case (1): The total value of the firm is $300,000. As the value of the firm is
less than its debt, the firm is bankrupt. The payoff to the debt holders will be
$300,000 and the payoff to the equity holders is zero.
Case (2): The total value of the firm is $500,000. This is precisely the value of
the firm’s debt, so the firm is solvent. The payoff to the debt holders is $500,000
and the payoff to the equity holders is zero.
Case (3): The total value of the firm is $1,000,000. This is more than the firm’s
debt, so the firm is solvent. The payoff to the debt holders is $500,000 and the
equity holders get the residual of $500,000.

3. You are among the OTC market makers in the stock of Bio-Engineering,
Inc. and quote a bid of 102 1/4 and an ask of 102 1/2. Suppose that you
have a zero inventory.

(a) On Day 1 you receive market buy orders for 10,000 shares and market
sell orders for 4,000 shares. How much do you earn on the 4,000 shares
that you bought and sold? What is the value of your inventory at the
end of the day? (Hints: It is possible to have negative inventory.
Further, there is more than one correct way to value an inventory,
but please state what assumption your valuation is based on.)

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 You have sold 10,000 shares at the ask price of 102 1/2. You bought 4,000 shares
at a bid price 102 1/4. Thus, 6,000 shares are sold short (sold without already
owning the security). Your revenue from the 4,000 “round trip” purchase and sale
produces a profit equal to the bid minus the ask times the volume done. Hence,
the profit on the round trip trades is $0.25 × 4, 000 = $1, 000.

The value of your inventory is equal to the value of your short position of 6,000
shares. Since there is both a bid and an ask price, this question can answered in
various ways depending on what you assume.
• The “conservative” valuation is to value your position at the ask price of
$102.50. Then, you have a position of -$615,000. This conservative valuation
is useful because if you cover your short position by buying from another
dealer at his ask price of 102 1/2 you would have to pay $615,000. Also, in
this example it is the price for which you sold the securities.
• The “aggressive” valuation is to value your position at the bid price of $102.25.
Then, you have a position of -$613,500 (i.e., less negative than above). This
value implicitly assumes that some investors will come to you and sell you
6000 shares at your current the bid.
• Often, real-world market makers will value their inventory at the mid price,
i.e., the average of the bid and ask prices, in this case 102 3/8. Then, you
have a position of -$614250.

(b) Before trading begins on Day 2 the company announces trial testing of
a cure for acne in mice. The quoted bid and ask jump to 110 1/4-1/2.
During Day 2 you receive market sell orders for 8,000 shares and buy
orders for 2,000 shares. What is your total profit or loss over the two-
day period? What is the value of your inventory at the end of Day 2?

You have bought 8,000 shares during Day 2 at 110 1/4 and sold 2,000 shares at 110
1/2. On the 2,000 you bought and sold during the day you earn 2,000×25=$500.
You also added 6,000 shares to your inventory at a price of 110 1/4. Since you
were short 6,000 shares at 102 1/2 from yesterday’s trading, your loss on these
6,000 shares is−$7.75 × 6, 000 = 46, 500. Thus your total profit/loss over the
two-day period is $1, 000 + $500 − $46, 500 = 45, 000.Your inventory at the end of
Day 2 is zero since you purchased 6,000 shares that offset the 6,000 share short
position at the end of Day 1.

(c) What is a market maker’s objective? Is there anything you could have
done during Day 1, consistent with a market maker’s objective, that
would have improved your performance over the two-day period?

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 A market-maker’s objective is to earn the bid-ask spread, and not (necessar-
ily) to speculate on equilibrium price movements. The 6,000 share short position
at the end of Day 1 left you vulnerable to an upward movement in prices. As
you observed more buying than selling, you could have tried to avoid this by in-
creasing your bid and/or ask price during Day 1. Increasing your ask would have
decreased demand, and you would not have sold so many shares. Also, you could
have tried to reduce your short inventory position by buying from other dealers.

4. Suppose that stock FFM is traded in the NYSE and all trading in that
stock is through a limit order book. Further, assume that at May 3, 2010
at 10:48 am the limit order book of FFM was empty. Following are the
trade orders for FFM after 10:48 am.

Time Investor Buy / Sell Order Type Quantity Price

10:49 A Buy Limit Order 1,000 $29
10:53 B Buy Limit Order 500 $30
10:57 C Sell Limit Order 3,000 $33
11:01 D Buy Limit Order 2,000 $29
11:04 E Sell Limit Order 1,000 $32
11:07 F Buy Limit Order 5,000 $28
11:12 G Sell Market Order 500
11:16 H Buy Limit Order 500 $32
11:19 I Sell Market Order 1,000

The limit order book is a system that holds all limit orders that were issued by investors
and are waiting to be executed. Let us take the view of the limit order book managers.
As the book managers, we are responsible for matching buyers and sellers at a fair price.

We will take it step by step to eliminate any misunderstanding. The attached file
”a1-q2-book-status” depicts the status of the book after the arrival of each order and
might be helpful. Although it looks long and complicated, the same principle is at
work again and again.

10:48 - There are no orders held in the book

10:49 - The first limit order arriving to the book is ”Buy 1,000 shares at $29 [per
share]” by investor A. This means that investor A is willing to buy 1,000 shares at a
maximum price of $29. As we have no sellers, we cannot match investor A’s order,
and so, we add her order to the book. The book can be viewed as holding two queues
- one of sellers and one of buyers.

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 Shares Price Client
Ask
Bid 1000 29 A

10:53 - The second limit order arriving to the book is ”Buy 500 shares at $30 [per
share]” by investor B. This means that investor B is willing to buy 500 shares at a
maximum price of $30. As we still have no sellers, we cannot match investor B’s order,
and so, we add her order to the book. Note that we add investor B’s order before
investor A’s order. This is called price priority. Prospective seller would rather trade
with a buyer that is willing to pay more.

Shares Price Client

Ask
Bid 500 30 B
1000 29 A

10:57 - The third limit order arriving to the book is ”Sell 3,000 shares at $33 [per
share]” by investor C. This means that investor C is willing to sell 3,000 shares at a
minimum price of $33. We compare the price of investor C’s order to prices of orders
already held in the book to ascertain if there is a match. Unfortunately, no buyer is
willing to pay $33 for the stock, and so there is no match, and we add investor C’s
order to the book as well.

Shares Price Client

Ask 3000 33 C
Bid 500 30 B
1000 29 A

11:01 - The fourth limit order arriving to the book is ”Buy 2,000 shares at $29 [per
share]” by investor D. This means that investor D is willing to buy 2,000 shares at a
maximum price of $29. As the only seller we have is investor C, who is willing to sell
at a minimum of $33, we cannot match this order as well. And so, we add investor
D’s to the book. Note that we add investor D’s order after investor A’s order. This is
called time priority, or, ”first in first served”. Since A arrives first it makes more sense
to deal with her order before the order of investor D.

Shares Price Client

Ask 3000 33 C
Bid 500 30 B
1000 29 A
2000 29 D

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11:04 - The fifth limit order arriving to the book is ”Sell 1,000 shares at $32 [per
share]” by investor E. This means that investor E is willing to sell 1,000 shares at a
minimum price of $32. We cannot match investor E as well, and we add her order
before the order of investor C (because of price priority).

Shares Price Client

3000 33 C
Ask 1000 32 E
Bid 500 30 B
1000 29 A
2000 29 D

11:07 - The sixth limit order arriving to the book is ”Buy 5,000 shares at $28 [per
share]” by investor F. This means that investor F is willing to buy 5,000 shares at a
maximum price of $28. This is the lowest buy order so far, and we add it to the end
of the buyers’ queue.

Shares Price Client

3000 33 C
Ask 1000 32 E
Bid 500 30 B
1000 29 A
2000 29 D
5000 28 F

Note that so far, orders have just arrived and were added to the book. The next
three orders will be matched with previously arriving orders and so we will have three
matches or transactions. Each match is done with a specific price. This is called the
transaction price.

11:12 - A sell market order of 500 shares of investor G arrives to the book. This mean
that investor G wants to sell now 500 shares at the best possible price, which is the
highest price of a buy order held by the book. We match investor G’s order with the
best buy order, which is the order of investor B. The transaction is 500 shares at
$30. Whenever we have a match, the transaction price is the price of the order which
was waiting in the book. Naturally, we eliminate the order of investor B from the book.

Shares Price Client

3000 33 C
Ask 1000 32 E
Bid 1000 29 A
2000 29 D
5000 28 F

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11:16 - the next limit order arrives to the book is ”Buy 500 shares at $32 [per share]” of
investor H. This means that investor H is willing to buy 500 shares at a maximum price
of $32. Fortunately, we can match investor’s H order with the sell order of investor E
held by the book. The transaction is 500 shares at 32$. Note though, that investor
E wants to sell 1,000, so we will leave her order in the book but now with a quantity
of 500.

Shares Price Client

3000 33 C
Ask 500 32 E
Bid 1000 29 A
2000 29 D
5000 28 F

11:19 - Last order is a sell market order of 1,000 shares of investor ”I”. This mean
that investor ”I” wants to sell now 1,000 shares at the best possible price. The best
possible price is the highest buy order - the order of investor A. The transaction is
1,000 shares at $29.

Shares Price Client

3000 33 C
Ask 500 32 E
Bid 2000 29 D
5000 28 F

Note: The general definition of bid is “the highest price at which an arriving trader
can sell shares”. In the limit order book it means - the price of the highest buy limit
order held in the book. The general definition of ask is “the lowest price at which an
arriving trader can buy shares”. In the limit order book it means - the price of the
lowest sell limit order held in the book.

The file “book-status”illustrates the bid and ask at different points in time.

Now, let us answer the questions:

(a) What is the Bid-Ask spread at the following points in time: 11:08 am,
11:13 am, 11:17 am, and 11:20 am?

The Bid-Ask Spread:

(a) At 11:08 - The bid-ask spread is $2 (Ask:$32, Bid:$30)
(b) At 11:13 - The bid-ask spread is $3 (Ask:$32, Bid:$29)
(c) At 11:17 - The bid-ask spread is $3 (Ask:$32, Bid:$29)

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 (d) At 11:20 - The bid-ask spread is $3 (Ask:$32, Bid:$29)

(b) What is the last transaction price as of the following points in time:
11:13 am, 11:17 am, and 11:20 am?

The last transaction prices are:

(a) At 11:13 - The last transaction price is $30
(b) At 11:17 - The last transaction price is $32
(c) At 11:20 - The last transaction price is $29

(c) How much money did investor A spend until 11:20 am. What about
investor D?

The buy limit order of investor A was executed at the price of $29 at 11:19.
Because her order was of 1,000 shares, she spent $29,000 (1,000 * 29 = 29,000).
The order of Investor D, on the other hand, is still in the book at 11:20, and
therefore she spent $0.

(d) Does the bid-ask spread vary greatly over time? Does the transaction
price vary greatly over time? How does this relate to the concept of
bid-ask bounce?

The bid-ask bounce refers to changes in (transaction) prices of a stock attributed

to the market structure and not to real changes in the value of the stock. Specif-
ically, since transactions are executed either at the bid price or at the ask price,
then a series of buy/sell orders will create a bouncing effect between the bid price
and the ask price. An observer might erroneously attribute the changes to high
volatility of the stock. The bid-ask bounce is apparent whenever the bid-ask
spread of the stock is wide (usually for small, illiquid stock). In our case, we have
a bid-ask bounce when the transaction prices bounce from 30 up to 32 and down
to 29. To summarize, while the transaction cost seems to vary greatly (30,32,29),
the bid price and the ask price remain (almost) constant in this example.

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 5. (Intended to make you think - give this question your best shot!) When
a company, say IBM, sells shares in the primary market, it receives money
directly, and therefore it has reason to care deeply about the price it re-
ceives. In contrast, when a share of IBM is sold by one investor to another
in the secondary market, IBM itself is not directly involved. Why does, or
should, IBM care about the price of its shares in the secondary market?

There are several reasons why IBM should care about its stock price:
• First, the shareholders are the owners of the company. The price of the shares in
the secondary market is directly related to the wealth of these investors, since it
is the price at which they can sell their shares. They would therefore prefer to
have high prices in the secondary market.
• It is also cheaper for the firm to obtain additional financing when the stock price
is high:
(a) When a firm wishes to issue additional shares (a seasoned equity offering, or
SEO), investors who are thinking of buying these shares will look at the price
of the firm’s existing shares trading in the secondary markets to get an idea
of the fair value of the security they want to buy. The firm can thus raise
more new capital by issuing new shares when the current stock price is high.
(b) If the company is doing well it will be less likely to default, and can hence
also obtain a lower borrowing rate by issuing bonds or when taking a bank
loan.
Shareholders elect the board of directors for the company. The shareholders might
design compensation contracts that pay managers huge salaries when share prices rise,
and very little if they don’t.1 Or they might fire management when the stock does
badly.

Furthermore, when stock prices are low relative to where they could be, the com-
pany becomes an attractive target for takeovers. That is, outside investors who think
that the company could be easily made worth more than it is at present, buy the
company at low prices and then work to increase the share price. Because the first
thing that happens in takeovers is that the current management is sacked, this gives
managers yet another reason to care about the stock price.

In sum, the reason companies want to keep share prices in the secondary markets
high is that the wealth of their owners, the shareholders, increases as the share price
increases. A variety of mechanisms exist by which managers are compelled to act in
the interests of the shareholders, and try to increase share prices.
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The typical way to do this is to grant stock options. Can you work out why giving the manager an
option to buy the stock at some time in the future would mean that he works very hard to raise the stock
price?