The Role of Markets in Business Decisions

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

Introduction to Business Module Assignment

Introduction to the IEM and the Business Market

In order for business managers to make appropriate strategic business decisions it is critical that they understand the competitive market environment of the business. These instructions are designed to provide students with an overview of the various markets and conditions under which they must develop competitive decision making strategies. Following the discussion of the market, students will be introduced to how the IEM is applied as a basic tool for understanding and using instruments to measure and assess selected markets.

The Iowa Electronic Market (IEM for short) is a computerized market in which financial contracts can be traded (bought or sold). For these assignments, we will be using a series of contracts based on Apple Computer (AAPL), IBM (IBM), Microsoft (MSFT), the S&P500 index, and the Federal Funds Rate. Shares of these firms trade over the counter (NASDAQ) and on the New York Stock Exchange (NYSE). A daily index value is determined for the S&P500 based upon the stock prices of the 500 companies that comprise the index, and the Federal Funds Rate is determined by the Federal Reserve during its Open Market Committee meetings.

These contracts are listed on the IEM under the market labels Computer Industry Returns Market (“Comp_Ret”), Microsoft Price Level Market (“MSFT_Price”), and the Federal Reserve Monetary Policy Market (“FedPolicyB”). These contracts are described briefly later in this note and in more depth in the IEM Trader’s Manual. Detailed descriptions of these markets are available at the IEM website:

http://www.biz.uiowa.edu/iem/markets/computer.html

http://www.biz.uiowa.edu/iem/markets/msft.html

http://www.biz.uiowa.edu/iem/markets/FedPolicyB.html

Objectives

The objectives of the IEM assignments are to help you apply class concepts in a "real world," unstructured way to learn how to:

1.  Understand the dynamics of the business markets and their impact on managerial decision making.

2.  Use the Federal Reserve Monetary Policy Market as a basis for understanding the influences of Fed Policies on interest rates and economic activities of businesses.

3.  Apply the Computer Industry Returns Market, and MSFT (Microsoft) Price Level Market modules to determine the growth and decline of the publicly traded stocks of these businesses.

4.  Apply the concepts of IEM in business financial market decisions.

What is the Iowa Electronic Market

The Iowa Electronic Market (IEM for short) is an on-line, computerized futures market where financial contracts can be traded (bought or sold) with payoffs based on real-world events such as political outcomes, stock price returns, box office receipts of motion pictures, etc. For this assignment students will be using the Federal Reserve Monetary Policy Market, the Computer Industry Returns Market, and MSFT (Microsoft) Priced Level Market modules.

Opening an IEM Account

All students need to open an account with the Iowa Electronic Market. This involves a minimum deposit of twenty dollars. Funds remaining in your account are refundable at the end of the semester.

You can open an IEM account over the Internet. To do so, go to the sign-up webpage:

http://iemweb.biz.uiowa.edu/signup/

and follow the instructions given to you by your instructor. (DO NOT use forms other than those given to you by your instructor. Using other forms may result in fees or decreased deposits in your account.)

After filling out your signup forms, you may need to deposit cash with the IEM office (W283 PBAB, phone 335-0881). Your instructor will give you details about any deposits you need to make.

Accessing the IEM

You can access the IEM through its website address:

http://www.biz.uiowa.edu/iem/

You access your trading account from the market pages or directly at:

http://iemweb.biz.uiowa.edu/

General information about the IEM can be found in the Trader’s Manual. This is a great resource, which includes a PowerPoint presentation about the IEM:

http://www.biz.uiowa.edu/iem/trmanual/

Specific information on how to navigate the IEM can be found in the WebExchange Users’ Guide:

http://iemweb.biz.uiowa.edu/webexmanual/

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:

Code / Contract Description / Liquidation Value
MSxxxmH
MSxxxmL / “Higher” contract
“Lower” contract / $1.00 3rd Friday closing > $xxx
$1.00 3rd Friday closing <= $xxx

In these contract codes, “m” refers to the month of expiration as given by the following table:

Month / Designation / Month / Designation / Month / Designation
January
February
March
April / a
b
c
d / May
June
July
August / e
f
g
h / September
October
November
December / I
j
k
l

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.

Symbol / Liquidation
MS105kH
MS105kL / $1
$0

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:

Code / Contract Description / Liquidation Value
AAPLm
IBMm
MSFTm
SP500m / Apple Computer
IBM
Microsoft
S&P 500 Market Index / $1.00 if AAPL NASDAQ Return Highest
$1.00 if IBM NYSE Return Highest
$1.00 if MSFT NASDAQ Return Highest
$1.00 if SP500 NYSE Return Highest

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
IBM
MSFT
SP500 / 36.6875
135.9375
105.0625
1056.42 / 35.3125
160.125
113.625
1163.55 / 0.00
0.22
0.00
-- / -3.748%
17.955%
8.150%
10.141% / $0
$1
$0
$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/.

The Directors of the IEM reserve the right to introduce new contracts to the market as spin-offs of existing contracts. When a contract spin-off occurs, an original contract will be replaced by new contracts. This divides the payoff range of the original contract into sub-intervals. No holder of the pre-spin-off contracts will be adversely affected. Traders will receive the same number of each of the new contracts as they held in the original. The sum of the liquidation values of the new contracts will equal the liquidation value that would be paid to the original in the absence of a spin-off. Decisions to spin-off a contract will be announced at least two days in advance of the spin-off. The new contract names, the specifications regarding liquidation values and the timing of the spin-off will be included in the announcement. This announcement will appear as a News Bulletin on the WebEx login screen.

Liquidation values will be set according to the contract descriptions. For example, if, at the close of the regularly scheduled FOMC meeting in month MMYY, the FOMC announces a decision to raise the target for the federal-funds rate, then each FRupMMYY contract held by a trader will be redeemed for $1.00, while the FRsameMMYY and FRdownMMYY contracts will expire with a $0.00 redemption value.

Note that liquidation values will depend solely on decisions made at the specific regularly scheduled FOMC meeting to change or not change the federal-funds rate target from its level as of the start of that same meeting. Neither changes in the federal-funds rate target made during the inter-meeting period nor decisions regarding other monetary policy issues or instruments will have any direct bearing on those liquidation values.

Contracts will be designated by a symbol and letter denoting up, down, or the same and the month and year of contract liquidation. Thus, the contracts traded in this market for liquidation in month “MM” and year “YY” are:

Code / Contract Description / Liquidation Value
FRupMMYY
FRsameMMYY
FRdownMMYY / $1.00 if the fed-funds rate target rises; $0 otherwise
$1.00 if the fed-funds rate target remains unchanged; $0 otherwise
$1.00 if the fed-funds rate target falls; $0 otherwise

The practice of the FOMC, initiated at the May 18, 1999 meeting, has been to release a public announcement shortly after each regular meeting describing the funds rate target decision. (See http://www.bog.frb.fed.us/boarddocs/press/General/1999/.) So long as that practice continues, this public announcement will be the official source of FOMC policy decisions for purposes of determining liquidation values. If no such statement is released by the FOMC, the Wall Street Journal will become the official source. Specifically, the most definitive statement of FOMC actions appearing in the three consecutive issues of the WSJ (Central Edition) after the close of the FOMC meeting will be taken as the policy decision. If the decision of the FOMC remains unclear even after three consecutive WSJ issues, the outcome "fed-funds rate target remains unchanged" will be declared the result for purposes of determining liquidation values. The judgment of the IEM Board of Governors will be final in resolving questions regarding the nature of the FOMC decision, including questions arising from typographical or clerical errors.

Trading in a set of contracts will continue for as much as two days beyond the end of the meeting on which those contracts are based. If an official announcement of the FOMC decision is made at the end of the meeting or within two days thereafter, the market will close and contracts will be liquidated as soon as is possible after the appearance of that announcement. If no official announcement has been made by 5:00 PM CST on the second business day after the end of the meeting, the market will close to further trading at that time. The following business day a decision regarding liquidation values will be made by the Board of Governors of the IEM based on reports appearing in the WSJ, with liquidations occurring shortly thereafter.

Trading on the IEM

You can trade on the IEM in several ways. First, you can buy or sell unit portfolios. A unit portfolio is a set of contracts such as AAPLm, IBMm, MSFTm and SP500m. You can always buy or sell such portfolios for $1.00 each. Thus, when you start to trade and do not own any contracts, you can buy a unit portfolio and then start to trade. (To do this, select the appropriate contract under “Buy Bundles” or “Sell Bundles” in the “Market Order” drop down menu. Enter a quantity and press the “Market Order” button.)