The IEM Assignment
Assignment Due: Last Class Meeting
Introduction
The Iowa Electronic Market (IEM for short) is a computerized market
on which financial contracts can be traded (bought or sold).
For use in finance classes, we have designed a special series
of contracts based on three popular companies: Apple Computers
(AAPL), IBM (IBM) and Microsoft (MSFT). Shares of these firms,
representing partial ownership, trade over the counter (on NASDAQ)
and on the New York Stock Exchange (the NYSE). Based on the share
prices of these firms, we have created two series
of contracts on the IEM under markets labeled the Computer
Industry Returns Market and the MSFT (Microsoft)
Price Level Market. These contracts are described briefly
here and in more depth in the IEM Trader's
Manual. News along with demand and supply of shares affect share
prices. For example, strong industry-wide sales can indicate
better prospects for any or all companies. This means that their
stock prices may increase. This, in turn, affects prices of the
contracts being traded on the IEM.
The basic objectives of the IEM assignment are to:
@familiarize students with a trading
environment (in this case, the IEM) where financial contracts
can be bought or sold.
@familiarize students with a financial
news and information sources.
@reinforce ideas from class including:
market efficiency, return calculations, stock valuation risk
and return and the CAPM.
Opening an IEM Account
All students need to open an account in the Iowa Electronic Market.
This involves a minimum deposit of ten dollars. The deposit
is refundable in full at the end of the semester if you do not
trade on the IEM but merely observe prices of the contracts being
traded. Following and analyzing market prices is sufficient for
the course and no transactions or risks are necessary for participation.
However, you may find that you wish to trade on your expectations.
To open an account, start by buying a Trader's Manual from the
copy center. Fill out the application that your TA will give
you and turn it in to the market administrator with any additional
cash you wish to deposit in you account. There are also forms
at the back of the manual that you can bring it to the IEM administrator
in W283 PBAB. You will then be registered for trading on the
IEM and have an account and password.
Address: IEM Administrator Phone: (319) 335-0881
W283 PBAB Email: IEM@SCOUT-PO.BIZ.UIOWA.EDU
University of Iowa
Iowa City, IA 52242
Accessing the IEM
You can access the IEM through one of the networks in PBAB or
any of the eleven ITC computer labs on the University of Iowa
campus (locations are in appendix C of the trader's manual).
To attach to the market, get the network menu on your screen and
select AIEM or Iowa
Electronic Markets.@ At any main level menu, you can type Am@ to select a market. Select the AComputer
Industry Returns@ or AMSFT (Microsoft) Price
Level@ markets to access
the contracts for this class.
You can access IEM from telnet. If your communications program
or TCP/IP telnet software has communication parameters, set them
to: Data bits-8, Parity-none; Stop bits-1. Enter one of the
following commands:
telnet iem.biz.uiowa.edu or telnet 128.255.44.2.
You can also connect via modem by dialing (319) 335-6200 and when
you see the prompt Aportal:@ on your screen, respond by entering: telnet iem.biz.
Computer Industry Contracts
The Computer Industry Contracts actually consist of two series
of contracts, one in the AComputer
Industry Returns Market@ and the other in the AMSFT
(Microsoft) Price Level Market.@ Every month, existing contracts in each series are liquidated
and payments are made as described below. Then new securities
are created for each series as described below. Payoffs are determined
on the day that the exchanged traded options for the underlying
stocks expire: the Saturday after the third Friday of each month.
Computer Industry Returns Contracts: The liquidation values
for these contracts 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 (dividend adjusted
for AAPL, IBM and MSFT and capital gains for SP500) as specified
below will payoff $1.00 per share. The remaining contracts will
payoff zero. (If two or more contracts tie for the highest return,
the $1.00 will be divided as evenly as possible among the tied
contracts with any residual $0.001's allocated in order of the
highest to lowest final values.) In addition, a letter designating
the month of contract designation will follow the ticker symbol.
Thus, the contracts traded in this market are:
Code Contract Description Liquidation Value
AAPLm Apple Computers $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
In these contract codes, Am@ refers to the month of expiration as given by the following table:
Month Designation Month Designation Month Designation
January a May e September l
February b June f October j
March c July g November k
April d August h December l
For AAPLm, IBMm and MSFTm, we will compute the dividend adjusted
rates of return based on closing stock prices of the underlying
listed firm between the option expiration dates in month Am@ and the previous month. For these purposes, we will use closing
prices from the third Friday of each month as given by the Monday,
Midwest edition of the Wall Street Journal.
The Dividend Adjusted Rate of Return is calculated as follows.
First, we compute the raw return on the underlying stock (the
closing price on the third Friday of the 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, we compute the capital gains return by
subtracting the previous month=s
closing index value from the current month=s
closing index value and then divide by the previous month=s
closing index value.
MSFT (Microsoft) Price Level Contracts: The liquidation
values for these contracts are determined solely by closing prices
Microsoft Common Stock (MSFT). Each month, an initial pair of
contracts consists of AMSxxxmH@ and AMSxxxmL@ where Am@ corresponds to the month as given above and Axxx@ corresponds to a price of $xxx. The payoff for the AH@ contract will equal $1.00 if the Wall Street Journal closing price
for Microsoft Common Stock on the third Friday of month Am@ exceeds $xxx. It will equal $0.00 otherwise. The payoff for
the AL@ contract will equal $1.00 if the Wall Street Journal closing price
for Microsoft Common Stock on the third Friday of month Am@ is less than or equal to $xxx. It will equal $0.00 otherwise.
Finally, we will choose $xxx to correspond to the strike price
of the exchange traded option that lies closest to the price of
Microsoft Common Stock on the third Friday of the previous month.
If the trading price of a particular contract becomes unusually
high, the Directors of the IEM may authorize a contract split.
When such a split occurs, the original contract will be split
into two contracts. The prospectus posted on the IEM discusses
stock splits.
Trading on the IEM
If you wish to trade, you can do so in several different ways.
First, you can buy or sell by accepting other traders= outstanding asks or bids. On the market screen, you will see
that some individuals have posted an order to buy (bid) or to
sell (ask) a contract (e.g., MSFTm) at a specific price. If you
believe that a posted order represents a good deal, you can buy
or to sell at the posted price.
Second, you can buy or sell unit portfolios. A unit portfolio is a set of contracts such as AAPLm, IBMm, MSFTm and SP500m. Such portfolios can always be bought or sold for $1.00 each. So when you start to trade and do not own any contracts, you can buy a unit portfolio and then start to trade.
Third, you can buy or sell by setting your own bid (to buy) or
ask (to sell). To do so, you state the price at which you are
willing to buy or sell a contract and then post the order on the
screen, thereby waiting for someone to come and be 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).
Grading
Your participation in the IEM will comprise 10% of your course
grade and consist of several parts.
Part 1: Trading on the IEM as a Securities Market
Trading on the IEM is structured much as it is on the NASDAQ and
NYSE. Thus, orders are similar to those on the NASDAQ and NYSE.
Identify how you would place the following types of orders:
i. A market order to purchase MSxxxmH.
ii. A limit order to sell MSxxxmL at $0.510.
iii. A limit order to sell IBMm at $0.450 that turns to market
at 5:00.
Part 2: Arbitrage on the IEM
Arbitrage opportunities sometimes arise on the IEM. From the
following bids and asks, identify the arbitrage opportunity and
explain how you would exploit it.
Contract Bid Ask
AAPLm 0.250 0.252
IBMm 0.336 0.339
MSFTm 0.401 0.405
SP500m 0.023 0.024
If you exploit the opportunity, what will eventually happen to
the level of the bids and/or asks for each security?
Part 3: Risk on the IEM
Part 3a: Select one security from the IEM MSFT (Microsoft) Price
Level Market. For a particular date, find that security=s
price. Assume that this price represents the probability that
this contract with pay $1. Thus, the contract will pay $0 with
a probability of 1 minus this price. What is the expected value
of this contract? What is the variance and standard deviation
in the contract=s value?
Part 3b: What is the market portfolio in the MSFT (Microsoft)
Price Level Market? What is the minimum risk portfolio? If you
hold the minimum risk portfolio, what is the variance in your
return? Given this, what is the correlation between MSxxxmH and
MSxxxmL?
Part 3c: What is the risk free asset in the IEM? What is its
return? Given this, what is the overall expected return for holding
any single contract in the IEM according to CAPM?
Part 4: Expected NYSE and NASDAQ Returns
Part 4a: For this part of the assignment, you are required to
find and record Abeta=s@ for each company=s common
stock. As we will explain in class, a company=s Abeta@ is a standard measure of the company=s
risk and should determine the returns expected for the company=s
stock. Beta=s can be
found from the following sources:
1. Value Line Investment Survey (ask for it at the Info Desk in the Business Library)
2. Standard & Poor=s Reports (in the Reference Collection of the Business Library)
For IBM, use the NYSE report, call number: HG4905.S66.
For AAPL and MSFT, use the OTC report, call number: HG4905.S663
3. S&P Stock Market Encyclopedia (in the Business Library) Call number: HG4921.S23
4. Bloomberg (ask about at the Information Desk in the Business Library)
Type in ticker symbol (e.g., AAPL) and press the green Quote 2 key.
Beta is in upper right hand corner #1.
5. Value Screen (in the computer lab).
Select the Value Screen group from windows.
Select the Value Screen icon.
Select AS@ for screen database.
Press AF-7@ and enter the ticker symbol (e.g., AAPL).
Finally AF-2@ to show the company=s
report, which includes beta.
Part 4b: Given the beta=s
you find, you should calculate the one-month CAPM expected return
for each company according to the following assumptions:
1. The one-month T-Bill return is: 0.45%.
2. The one-month expected market return is: 1.00%
Part 4c: Given this information you should determine which security
in the returns market should be priced the highest on the day
that trading in this market opens and explain why this should
be the case.
Part 5: Discounted Dividend Model Valuations
Part 5a: Fixed Dividend Model. You should find the most recent
quarterly dividend for one of the companies (AAPL, IBM or MSFT).
The IEM news sections with contain recent dividend information
for each contract. Given this, you should calculate prices according
to the following assumptions:
1. The company pays fixed, quarterly dividends equal to the last dividend paid.
2. The next dividend will be paid in exactly one quarter.
Explain why the stock prices calculated here might differ from
those found the Wall Street Journal.
Part 5c: Historical Growth Model. To get a more realistic estimate
of the company=s stock
price, look up the five year historical growth rate in dividends
(using Bloomberg, ValueScreen or company annual reports). Use
this as the growth rate along with last quarter=s
dividend and the CAPM required return to find the price of the
company=s stock using
the Gordon growth model.
Part 5d: A Simple Projected Growth Model. To get an alternative
estimate of the company=s
stock price, look up the company=s
ROE and retention rate (using Bloomberg, ValueScreen or company
annual reports). Determine the projected growth rate in dividends
from these numbers and find the price of the company=s
stock using the Gordon grown model, the CAPM required return
and this projected growth rate.
Part 5e: Pro-Forma Analysis (Advanced). Here, you will use pro-forma
analysis as an alternative means of determining dividends. To
do this, obtain last years balance sheets and cashflow statements
for one of the companies from the annual report, Edgar, Bloomberg,
ValueScreen or some other source. From the same source, find
the five year growth rate in sales. Project the financial statements
for this company for the next five years using the percent of
sales method. Assume that the capital structure stays fixed and
the retention ration stays fixed. Assume that the average growth
rate in dividends projected for the next five years will hold
forever and find the price of the company=s
stock using the Gordon grown model, the CAPM required return
Part 5f: The Implied Growth Rate. As an alternative way of determining
growth rates, use the current dividend, the CAPM required return
and the current stock price to solve for the growth rate according
to the Gordon growth model.
Part 5g: Given the information above, what do you believe the
current stock price and growth rate in dividends should be? Be
sure to be consistent and justify your answer.
Part 6: Price and News Log
For this part of the assignment, you are required to build a price
and news log for the companies trading in the Computer Industry
Market. Specifically, to construct a price log, choose an eight
consecutive week period during the semester and record the following
information once a week on the same day each week:
1. Wall Street Journal closing prices for each underlying security.
IBM stock prices can be found in the NYSE Composite Index each
day; Microsoft and Apple stock prices can be found in the NASDAQ
Index each day and the S&P500 Index is listed in the upper
left corner of page C1 each day.
2. IEM last trade prices for each IEM traded security.
These prices can be found under AContract
Daily Prices@ in the AMarket Information@ screen on the IEM.
You are also asked to find one news article from any source on
each company (Apple, Microsoft and IBM) that you believe should
affect stock prices for that company. For each article, you should
explain how you believe the information will effect prices for
the company=s stock
and prices for the company=s
securities on the IEM. In particular, how do you think this
news will effect prices and dividend growth rates from part 5?
Then, you should compare your predictions to the actual price
changes recorded in your price log.
Part 7: Actual Returns and Payments
The trading log you created in Part 1 will contain at least one
complete cycle of creating, trading and liquidation for the securities
traded in the Computer Industry Markets. (This cycle will run
from the third Friday in one month to the third Friday in the
next month.) Select one monthly trading cycle to complete this
part of the assignment.
Part 7a: For that month, calculate the capital gains return for
each stock (AAPL, IBM and MSFT) and the S&P500. To do this,
use the closing prices from the third Friday in each month.
Part 7b: Calculate the Dividend Adjusted (Total) Returns for that
month for each stock (AAPL, IBM and MFST). Again, the IEM news
screens will contain dividend information.
Part 7c: The actual returns calculated here will likely differ
from those calculated from the CAPM above. Explain why they might
differ.
Part 7d: From the monthly total returns on the stocks and the
capital gains return on the S&P500, calculate Effective Annual
Yield (EAR) for each stock (AAPL, IBM and MFST) and the S&P500.
Part 7e: From you calculations and price log, determine which
IEM securities should have paid off $1 and which should have paid
off $0. Did they? Explain any discrepancies you find.
Completing Your Assignment and Submitting It
As you can see, this is an extensive, multi-part assignment that
draws together many concepts from the class. It would be wise
to work on the various parts of the assignment as we go over the
relevant topics in class. To prepare the assignment for submission,
please use the following guidelines:
1. Clearly label your assignment with a cover page giving your name, student number, TA section number and your TA=s name.
2. Complete each part in a separate section clearly labeling them APart 1,@ APart 2@ and APart 3.@
- Within each section, give the requested information, including sources of information gathered and equations for calculated results.
4. Turn in your completed assignment to your TA on or before the last TA session (December 8).
