Trading Case RE1
Case Objective
The concept of market efficiency is central to modern finance theory. In this case you will gain experience with this important concept.
Key Concepts
Efficient Markets Hypothesis, Dividend Model, Prediction Markets.
Case description
In a trading trial two stocks are traded over two periods. Each stock pays dividends at the end of periods 1 and 2 depending upon economic events, as described in a later section of this case. At the end of each trial your position is converted to cash and so the second dividend is a liquidating dividend. The interest rate is 0% each period and can be borrowed or lent at this interest rate. In addition, you can sell stocks that you do not currently own. This is referred to as short selling and if you are short, your stock position is displayed as a negative number. If you are short at the end of either trading period, the realized dividend is automatically subtracted from your cash account. That is, you are obligated to cover all dividends paid by a stock during the time you are short.
Per Share Dividends
Firms compete in different product markets, and the events relating to each firm’s product market are independent across firms. However, within a product market, period 2 events depend upon period 1 events and therefore the period 2 dividend depends upon the period 1 dividend. You may receive private information (for period 1 and/or period 2 in the form of “Per 1 Not x”, “Per 2 Not y” etc.,) about these events. That is, your information will eliminate possible market events (see dividend table below). This information is displayed on your trading screen when you click on the stock’s name.
Case Data
The following table describes the equally likely events affecting each firm, and the dividends paid at the end of period 1
|
Firm ABC |
|
Dividend |
|
Event x |
Poor economic conditions, labor strike |
0 |
|
Event y |
Poor economic conditions, no strike |
12 |
|
Event z |
Fair economic conditions, good labor relations |
24 |
|
Firm CRA |
|
Dividend |
|
Event w |
Poor economic conditions, labor strike |
0 |
|
Event x |
Poor economic conditions, no strike |
12 |
|
Event y |
Fair economic conditions, no strike |
12 |
|
Event z |
Fair economic conditions, good labor relations |
24 |
The dividends paid at the end of period 2 depend on both the period 1 event and the period 2 event. In the table below, if in periods 1 and 2 the realized events are z and x, respectively, for ABC, then the period 1 realized dividend is 24, and the period 2 realized dividend is 12 denoted as 24,12 below.
Firm ABC
|
Period 1 Event |
Period 2 Event |
||
|
|
X |
y |
z |
|
X |
0,0 |
0,0 |
0,12 |
|
Y |
12,0 |
12,12 |
12,24 |
|
Z |
24,12 |
24,12 |
24,24 |
Firm CRA
|
Period 1 Event |
Period 2 Event |
|||
|
|
w |
x |
y |
Z |
W |
0,8 |
0,8 |
0,12 |
0,18 |
|
X |
12,8 |
12,8 |
12,12 |
12,18 |
|
Y |
12,8 |
12,8 |
12,12 |
12,18 |
|
Z |
24,8 |
24,8 |
24,12 |
24,18 |
Sequence of Events
In this case each period corresponds to 1 calendar year. You trade only during the first day of each year and then time flashes forward to the end of the year and the following sequence of events occur. First, dividends are paid (subtracted) on the basis of any positive (negative) stock holding. Second, your cash/stock position carries forward to the second year. At this time the market opens again for the first trading day. Third, at the end of year 2 the dividend is a final liquidating dividend and your stock position is cashed out. Your trading bonus and rank in the market are now computed. Fourth, trial 1 is over and a short time later trial 2 starts with a new initial position.
Your aim is to make as much money as you can which depends upon how well you trade relative to the prices discovered by the market. In each trial you earn a trading bonus or grade cash calculated from: 0.0001 times your closing balance of 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. The grade cash will determine your rank in each trading trial.
Trading is conducted over a number of independent trials and performance can be assessed in terms of your average rank across trials.