Homework Assignment – Chapter 13

  1. Name two differences between common and preferred stock.

Common Stock

  • Has voting rights
  • Pays dividends
  • Holder hopes/expects that the price will rise

Preferred Stock

  • Pays a fixed dividend
  • Price is relatively stable
  • Votes only if the firm fails to pay the dividend
  • Much more like a corporate bond than common stock
  1. Describe the difference between brokers and market-makers. Describe the difference in how they are paid.

A broker is a pure middle man whose job it is to bring together buyers and sellers. They earn a commission for this service. A market-maker quotes a bid and an offer price and earns money by buying shares at the bid and selling shares at the offer.

  1. How does a market order work?

This is an order to buy(sell) shares at the best possible price in the market. It will be filled as long as there are willing sellers (buyers).

  1. What is the difference between a Market if Touched order and a Stop order.

A Market if touched buy order will create a market order if the market falls to the specified price. The price in the market if touched buy order is below the current price. A Stop order will create a market order if the market rises to the price specified in the order.

  1. What is the difference between a Fill-or-Kill order and an Intermediate or Cancel order.

A Fill-or-Kill order is one that will be cancelled if it cannot be immediately filled. No partial fills are allowed. An Intermediate-or-Cancel order can be partially filled and will be cancelled immediately after being filled as completely as possible.

  1. Describe an iceberg order. What purpose does it serve in the market? How else could you execute such an order?

An iceberg order is an order in which only part of the order is displayed at one time. For example a 100,000 iceberg order might show 10,000 shares at a time. Once the 10,000 share portion of the order has been filled then the next 10,000 shares will be entered into the order book. This will repeat until the entire order is filled.

  1. Describe an Electronic Communication Network. What advantages do ECNs provide? What might be some of their disadvantages?

An ECN is essentially an electronic order book. A subscriber to the ECN has access to the order book and also the ability to enter orders. The ECN provides transparency, anonymity, automated service and a low cost of trades. This makes it suitable for small trades. It is not necessarily good for larger trades. In addition it is dependent on subscribers to have good prices. If it is too small then liquidity will be a problem.

  1. What is the role of the designated market maker (DMM) on the NYSE?

A designated market maker is tasked with maintaining a fair and orderly market in the stocks for which they are the DMM. In addition they run the opening and closing auctions and manage their stock during times of stress in the market.

  1. What is a crossing network?

A crossing network is a network that matches buyers and sellers of larger trades using prices from elsewhere. These will often be the mid price seen in an order book at a certain point in time or the closing price of a stock.

  1. What are soft dollars? Why are they open to abuse?

Soft dollars refer to money that a broker’s client pays in additional commissions for services such as research. As soft dollars are paid through commissions it is very difficult to identify what portion of a commission is a soft dollar and what portion is commission and thus these are open to possible abuse. In the past clients have used soft dollars to pay for vacations and expensive restaurants.

Quantitative Problems – Chapter 13

  1. A trader buys 1000 shares of a stock for $100. He pays a broker $1 dollar per share commission. After two weeks the stock has risen to $112 dollars. If the trader sells the shares for $112 again with a $1 commission what is his total return in dollars? In percent?

The trader makes 1000(112-100-2) = 1000(10)= 10,000 dollars. His return in percent is 10,000/100,000 = 10%.

  1. A trader wants to short 1000 shares of a stock at $100. His broker is able to locate the shares for him at a cost of 0.5% (use a daily charge of 0.5% x 1/365). The broker is not going to pay the trader interest on the proceeds from his short. If he sells the stock short at $100 and buys it back 14 days later at $90 and the broker charges a $1 commission per share what is his total return in dollars? In percent?

The trader makes 1000(100-90–2-0.005x100x14/365) = $7,980.82 or

$7,980.82/100,000 = 7.98%

  1. A trader wants to short 1000 shares of a stock at $75. His broker is able to locate the shares for him at a cost of 1.5% (use a daily charge of 1.5% x 1/365). The broker will pay interest to the trader of 0.5% on the proceeds of his short position. If he sells the stock short at $75 and buys it back 28 days later at $90 and the broker charges a $1 commission per share what is his total return in dollars? In percent?

The trader makes 1000(75-90-2-0.015x75x28/365+.005x75x28/365)=-16,884 or -16.89%.

  1. On two different ECNs there are separate order books. Identify the arbitrage between the markets.

Bid Quantity / Bid Price / Offer Price / Offer Quantity
10,000 / 102 / 104 / 15,000
5,000 / 101 / 105 / 7,000
2,000 / 100 / 108 / 5,000
Bid Quantity / Bid Price / Offer Price / Offer Quantity
10,000 / 100 / 101 / 15,000
5,000 / 99 / 102 / 7,000
2,000 / 98 / 105 / 5,000

You can buy the shares at 101 from the second ECN and sell them at 102 from the first. There are 10,000 shares available for this.

The following questions all relate to the following order book. Explain what happens to the trader’s order and update the state of the order book. The problems will all be sequential as in each problem will change the state of the order book and you will do the next problem with the state of the order book as the last problem left it. Any unfilled orders may become active in later parts of the problem.

Bid Quantity / Bid Price / Offer Price / Offer Quantity
10,000 / 100 / 101 / 15,000
5,000 / 99 / 102 / 7,000
2,000 / 98 / 105 / 5,000
  1. A trader places a limit sell order for 12,000 shares at a price of 100.

Of the 12,000 shares 10,000 are filled from the first Bid in the order book. The remaining 2,000 are added to the order book.

Bid Quantity / Bid Price / Offer Price / Offer Quantity
5,000 / 99 / 100 / 2,000
2,000 / 98 / 101 / 15,000
102 / 7,000
105 / 5,000
  1. A trader places a limit buy order for 7,000 shares at a price of 100.

There are 2,000 shares available at a price of 100. These are bought and the remaining 5,000 shares are added to the order book

Bid Quantity / Bid Price / Offer Price / Offer Quantity
5,000 / 100 / 101 / 15,000
5,000 / 99 / 102 / 7,000
2,000 / 98 / 105 / 5,000
  1. A trader places a market if touched sell order for 5,000 shares at 102.

This order is not filled immediately as the market is not at 102. It will wait for an order to touch 102. The order book is unchanged.

  1. A trader places a market order to buy 20,000 shares.

This order is filled immediately with 15,000 share being bought at 101 and 5,000 share being bought at 102. This then triggers the market if touched sell order from problem 3. This will sell the 5,000 shares at a price of 100 which is the highest bid in the order book. The order book will look like:

Bid Quantity / Bid Price / Offer Price / Offer Quantity
5,000 / 99 / 102 / 2,000
2,000 / 98 / 105 / 5,000

The following questions all relate to the following order book.Explain what happens to the trader’s order and update the state of the order book. The problems will be sequential. Each problem may change the state of the order book and you will do the next problem accordingly. Any unfilled orders can become active in later parts of the problem.

Bid Quantity / Bid Price / Offer Price / Offer Quantity
10,000 / 100 / 101 / 15,000
5,000 / 99 / 102 / 7,000
2000 / 98 / 105 / 5,000
  1. A trader places a fill-or-kill limit sell order for 12,000 shares at a price of 100.

There are only 10,000 shares available to sell at 100 so this order cannot be filled. Thus it is killed and the order book is unchanged.

Bid Quantity / Bid Price / Offer Price / Offer Quantity
10,000 / 100 / 101 / 15,000
5,000 / 99 / 102 / 7,000
2000 / 98 / 105 / 5,000
  1. A trader places a limit buy order for 7,000 shares at a price of 100.

This order is simply added to the current buy order at 100.

Bid Quantity / Bid Price / Offer Price / Offer Quantity
17,000 / 100 / 101 / 15,000
5,000 / 99 / 102 / 7,000
2000 / 98 / 105 / 5,000
  1. A trader places a stop-order to sell 5,000 shares at a price of 99.

Nothing happens to this order right now as the stock price has not fallen to 99

  1. A trader places a limit sell order for 12,000 shares at a price of 100.

This order is filled from the 17,000 shares bid at 100. The order book will then look like:

Bid Quantity / Bid Price / Offer Price / Offer Quantity
5,000 / 100 / 101 / 15,000
5,000 / 99 / 102 / 7,000
2000 / 98 / 105 / 5,000
  1. A trader places a market sell order for 6,000 shares.

This order is filled with 5,000 shares at 100 and 1,000 shares at 99. This then triggers the stop order. The stop order then becomes a market sell order for an additional 5,000 shares. This order is filled with 4,000 shares at 99 and 1,000 shares at 98. The order book then looks like.

Bid Quantity / Bid Price / Offer Price / Offer Quantity
1,000 / 98 / 101 / 15,000
102 / 7,000
105 / 5,000

The following questions all relate to the following order book.Explain what happens to the trader’s order and update the state of the order book. The problems will be sequential. Each problem may change the state of the order book and you will do the next problem accordingly. Any unfilled orders can become active in later parts of the problem.

Bid Quantity / Bid Price / Offer Price / Offer Quantity
10,000 / 100 / 101 / 15,000
5,000 / 99 / 102 / 7,000
2,000 / 98 / 105 / 5,000
  1. A trader places a intermediate-or-cancel limit sell order for 12,000 shares at a price of 100.

The first buyer buys 10,000 shares at 100. As this is an intermediate-or-cancel trade these shares are bought and the rest of the order is cancelled. The new order book looks like:

Bid Quantity / Bid Price / Offer Price / Offer Quantity
5,000 / 99 / 101 / 15,000
2,000 / 98 / 102 / 7,000
105 / 5,000
  1. A trader places a limit buy order for 7,000 shares at a price of 100.

There are no sellers at a price of 100. As this is a limit buy order it is added to the order book.

Bid Quantity / Bid Price / Offer Price / Offer Quantity
7,000 / 100 / 101 / 15,000
5,000 / 99 / 102 / 7,000
2,000 / 98 / 105 / 5,000
  1. A trader places a stop-limit-sell order for 5,000 shares at a price of 99.

The market is currently at 100 and thus this order stays valid but does not yet appear in the order book.

Bid Quantity / Bid Price / Offer Price / Offer Quantity
7,000 / 100 / 101 / 15,000
5,000 / 99 / 102 / 7,000
2,000 / 98 / 105 / 5,000
  1. A trader places a limit sell order for 12,000 shares at a price of 100.

This order is partially filled for 7,000 shares. The remaining 5,000 shares appears in the order book.

Bid Quantity / Bid Price / Offer Price / Offer Quantity
5,000 / 99 / 100 / 5,000
2,000 / 98 / 101 / 15,000
102 / 7,000
105 / 5,000
  1. A trader places a market sell order for 6,000 shares.

As this is a market sell order it will sell shares into the market if these are available. Thus the trader will sell 5,000 shares at 99 and 1,000 shares at 98. This activates the stop limit sell order from problem 12. There are no shares available for sale at 99 and thus the 5,000 shares at 99 will be added to the order book.

Bid Quantity / Bid Price / Offer Price / Offer Quantity
1,000 / 98 / 99 / 5,000
100 / 12,000
101 / 15,000
102 / 7,000
105 / 5,000