Trading Case RE3
Case Objective
To understand the role of option markets and option trading strategies in promoting market efficiency.
Key Concepts
Market efficiency; rational expectations; option trading strategies.
Case description
There are two non-dividend paying stocks, traded over two periods. The values of the stocks at the end of the second period depend on whether the firms maintain lucrative contracts. The interest rate each period is set at 0%, so the time value of money plays no role in this case. You can borrow at this rate and also short sell the stocks. In each period, a firm can win or not win contracts. The firms do not compete for the same contracts. Winning all the contracts is the best event, while not winning anything is the worst event. You may receive information about these events.
In addition to the stock markets trading shares in Firm 1 and Firm 2 respectively. In addition, there are two European style options defined on stock 1: a call option with strike 30 and a put option with strike 30. All prices are discovered by the traders in the market.
Case Data
The following table describes the events. Each event is equally likely.
|
Event x |
Failure to win any contract |
|
Event y |
Wins some contracts |
|
Event z |
Wins all the contracts |
|
|
|
The values of the firms at the end of the second period depend on bidding success in each period:
|
Period 2 events |
||||||
|
|
1 Share in Firm 1 |
1 Share in Firm 2 |
||||
|
|
x |
y |
z |
x |
y |
z |
|
X |
0 |
20 |
40 |
0 |
20 |
40 |
|
Y |
0 |
25 |
45 |
0 |
25 |
45 |
|
Z |
0 |
35 |
60 |
0 |
35 |
60 |
|
Period 1 event |
Period 2 events |
|||||
|
|
1 Call 30, Firm 1 |
1 Put 30, Firm 1 |
||||
|
|
x |
y |
z |
x |
y |
z |
|
X |
0 |
0 |
10 |
30 |
10 |
0 |
|
Y |
0 |
0 |
15 |
30 |
5 |
0 |
|
Z |
0 |
5 |
30 |
30 |
0 |
0 |
Private Information
All traders get private information about the period 1 and period 2 events for each firm. The private information will be displayed as follows for the stock in each firm:
Per1: Not x, or Not y, or Not z where x,y,z refer to the corresponding firm specific event and similarly for Per 2 information. This information is never false.
A single click on the name Stock 1 or Stock 2 reveals your private information in the text box (top middle of the FTS Trader screen) immediately after the market opens for trading.
The markets are open at the beginning of each year for two years. Each pair of trading periods is defined as one trial. Your objective is to accumulate as much grade cash as possible for each trial by managing the expected end of trial market cash value of your position.
Your grade cash in any trial is 0.0001 x market cash. That is, if you end up with negative wealth then you lose grade cash and if you make money then you gain grade cash. Trading is conducted over a number of independent trials and a record of your cumulative grade cash is maintained.