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### Entire Unit Module.doc.doc

1. 1. The Iowa Electronic Markets The Role of Markets in Business Decisions Curriculum using the IEM Prepared for Introduction to Business Courses By Sal Veas Charley Lee Morrow Santa Monica College Delaware State University
5. 5. • Federal Reserve Monetary Policy Market • Computer Industry Returns Market • MSFT (Microsoft) Price Level Market 8. BUSINESS FUNCTION SPECIFIC MODULES • Economics • Forms of Business Ownership • Global Business • Marketing • Money and Banking • Finance • Securities • Personal Finance
8. 8. Contracts Computer Industry Contracts The Computer Industry Contracts consist of two series of contracts. Every month, existing contracts in each series are liquidated and payments are made as described below. Then, new contracts are created for each series. 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). MSFT (Microsoft) Price Level Market: The liquidation values for the contracts in this market are determined solely by closing prices of Microsoft Common Stock (MSFT) on NASDAQ (the National Association of Security Dealers Automated Quotation system). Thus, to do well in this market, you will need to understand what determines real stock market prices. Contracts and Liquidation Rule: Each month, an initial pair of contracts consists of "MSxxxmH" and "MSxxxmL" where “m” corresponds to the month as given below and “xxx” corresponds to a price of \$xxx. The payoff for the "H" contract will equal \$1.00 if the Wall Street Journal closing price for Microsoft Common Stock on the third Friday of month “m” exceeds \$xxx. It will equal \$0.00 otherwise. The payoff for the "L" contract will equal \$1.00 if the Wall Street Journal closing price for Microsoft Common Stock on the third Friday of month “m” is less than or equal to \$xxx. It will equal \$0.00 otherwise. Thus, the contracts traded in this market for liquidation in month “m” are:
9. 9. Code Contract Description Liquidation Value
10. 10. MSxxxmH “Higher” contract \$1.00 3rd Friday closing > \$xxx MSxxxmL “Lower” contract \$1.00 3rd Friday closing <= \$xxx
11. 11. In these contract codes, “m” refers to the month of expiration as given by the following table:
12. 12. Month Designation Month Designation Month Designation
13. 13. January a May e September I February b June f October j March c July g November k April d August h December l
14. 14. For example, consider the Microsoft contracts for the November 1998 trading month. They were MS105kH and MS105kL. The first contract would pay a dollar if the closing price of Microsoft on the third Friday of November (11/20/98) were greater than \$105. The second contract would pay one dollar if the closing price of Microsoft on 11/20/98 were less than or equal to \$105. On November 20, Microsoft closed at \$113.625. The table below shows the liquidation values of the two contracts traded on the IEM.
15. 15. Symbol Liquidation
16. 16. MS105kH \$1 MS105kL \$0
17. 17. Computer Industry Returns Market: The liquidation values for the contracts in this market are determined solely by the rates of return of Apple Computer 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, by predicting which company will do well in the stock market will help you predict what contracts will do well in the IEM. Contracts: Contracts will be designated by a “ticker symbol” (this is an abbreviation used by the stock market to designate a company) and a letter denoting the month of contract liquidation. Thus, the contracts traded in this market for liquidation in month “m” are:
18. 18. Code Contract Description Liquidation Value
19. 19. AAPLm Apple Computer \$1.00 if AAPL NASDAQ Return Highest IBMm IBM \$1.00 if IBM NYSE Return Highest MSFTm Microsoft \$1.00 if MSFT NASDAQ Return Highest SP500m S&P 500 Market Index \$1.00 if SP500 NYSE Return Highest
20. 20. In these contract codes, “m” refers to the month of expiration as given in the Microsoft Price Level description above. Liquidation Rule: For AAPLm, IBMm and MSFTm, liquidation values are determined by the dividend- adjusted rate of return for the associated stock. The dividend adjusted rate of return computed from 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. Since the S&P500 index does not pay a dividend, the return is computed as the capital gains rate of return for the SP500 contract. 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. The contract associated with the stock (or index) that has the highest return will pay \$1. All other contracts will pay \$0. For example, consider the returns for the November 1998 trading month. The following table shows the stock prices on the third Friday in October and in November along with dividends paid. Symbol Price10/16/98 Price11/20/98 Dividends Paid Returns Liquidation AAPL 36.6875 35.3125 0.00 -3.748% \$0 IBM 135.9375 160.125 0.22 17.955% \$1 MSFT 105.0625 113.625 0.00 8.150% \$0 SP500 1056.42 1163.55 -- 10.141% \$0 The returns are calculated as follows: RAAPL = (35.3125-36.6875)/ 35.3125 = -3.748% (Indeed, returns can be negative!) RIBM = (160.125+0.22–135.9375)/135.9375 = 17.955% (IBM paid a dividend of 0.22.) RMSFT = (113.625-105.0625)/105.625 = 8.1505% RSP500 = (1163.55-1056.42)/1056.42 = 10.141% Price and dividend information can be found in the Wall Street Journal, on the IEM itself and through various online sources. The Federal Reserve Monetary Policy Market The Federal Reserve Monetary Policy Contracts consist of three contracts. After every FOMC meeting, existing contracts in the series are liquidated and payments are made as described below. Then, new contracts are created as described below. The schedule of FOMC meetings can be found at the Federal Reserve System's web site: http://www.bog.frb.fed.us/fomc/.