Essay on Finance 1

1925 Words Nov 22nd, 2014 8 Pages
Topic 1: Financial Markets
1. You are among the OTC marketmakers in the stock of BioEngineering, Inc. and quote a bid of $102.25 and an ask of $102.50. 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.)
You have sold 10,000 shares at the ask price of $102.50. You bought 4,000 shares at a bid price $102.25. Thus, 6,000 shares are sold short (sold
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(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 $110.25 and $110.50, respectively.
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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 $110.25 and sold 2,000 shares at $110.50. On the 2,000 you bought and sold during the day you earn 2, 000 × $0.25 = $500. You also added 6,000 shares to your inventory at a price of $110.25. Since you were short 6,000 shares at $102.50 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?
A marketmaker’s objective is to earn the bid-ask spread, and not (necessarily) to speculate on equilibrium price movements. The 6,000 share short position at the end of Day 1 left you vulnerable to a jump in quoted prices. Perhaps you should have increased the prices during Day 1 as you observed more

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