1 Trading Case RE1

Case Objective The objective of this case is to familiarise you with the Financial Trading System (FTS). In addition:

Dividends have an impact on the price of both the underlying financial instruments, and their related derivatives (e.g. share options). This means that an understanding of the dividend model is important. Market efficiency is central to modern finance theory. This case will also give you insights into this important concept.

Key Concepts Dividend Model, Efficient Markets Hypothesis. Case description Trading sessions are made up of trading trials, which are simply repeats of the given trading exercise. In each trial there are a number of time periods.
Trial 1 Period 1 Period 2 Trial 2 Period 1 Period 2 3 4

In each RE1 trading trial two stocks (ABC and CRA) are traded over two periods. Each stock pays dividends at the end of periods 1 and 2 depending upon economic events, as described later. At the end of each trial your position is converted to cash and so the second dividend is a liquidating dividend (i.e. it is based on the total liquidation of the company, so that there is no value left in the shares after this dividend). To keep the case simple so you can focus on learning about FTS, the interest rate is 0% in each period. You can borrow or lend at this interest rate. The dividend model for valuing shares for a multi-year holding period, with multiple dividends is:

P0 =

D1 D2 Dn Pn + + ... + + 1 2 n (1 + r) (1 + r) (1 + r) (1 + r) n

where P0 = the share price today, Di = the dividend in period i, r = the required rate of return, and Pn = the share price in the final period, when the shares are sold. To simplify this case, r = 0 and the final dividend is liquidating, so Pn = 0. This means the present value of the stock is simply the sum of the two dividends paid (i.e. P0 = D1 + D2). 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 a trading period, the realised dividend is automatically deducted from your cash account, as you will have to pay the dividend yourself. 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 firms product market are independent across firms. In this case, the events are labelled w, x, y, and z, and are described in the table on the next page. 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. In period 1 you will receive private information about these events in both future periods e.g. Per 1 Not x, Per 2 Not y, meaning that event x will not occur in period 1 and event y will not occur in Period 2. This information is never false, and eliminates some market outcomes (see the dividend table on the next page). This private information is displayed on your trading screen when you click on the stocks name. Case Data

Original case 1999 OS Financial Trading System. Used with permission.

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The following table describes the equally likely events affecting each firm, and the dividends paid at the end of period 1. All events are mutually exclusive i.e. only one event can occur per period.
Firm ABC Event x Event y Event z Firm CRA Event w Event x Event y Event z Poor economic conditions, labour strike Poor economic conditions, no strike Fair economic conditions, good labour Poor economic conditions, labour strike Poor economic conditions, no strike Fair economic conditions, no strike Fair economic conditions, good labour Dividend 0 12 24 Dividend 0 12 12 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 realised events are z and x, respectively, for ABC, then the period 1 realised dividend is 24, and the period 2 realised dividend is 12, denoted as 24,12 below.
Firm ABC Period 2 Event x y z 0,0 0,0 0,12 12,0 12,12 12,24 24,12 24,12 24,24 Firm CRA Period 2 Event w x y 0,8 0,8 0,12 12,8 12,8 12,12 12,8 12,8 12,12 24,8 24,8 24,12

Period 1 Event x y z

Period 1 Event w x y z

z 0,18 12,18 12,18 24,18

Opening position When the market starts you will have one of two opening positions:
Cash ABC shares CRA shares Position 1 $3250 0 75 Position 2 $750 100 75

Trading Screen Your initial trading screen will look something like this:

Sequence of Events Each period in a trial 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 (or subtracted) on the basis of any positive (or short sold) stock holding. Second, your cash/stock position carries forward to the second year. At this time the market opens again for the first

Original case 1999 OS Financial Trading System. Used with permission.

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trading day. Third, at the end of year 2 the dividend is a final liquidating dividend and your stock position is cashed out. Your grade cash (see below) and rank in the market are now computed. Fourth, trial 1 is over and (if time permits) a short time later trial 2 starts with a new initial position. There is no relationship between your position in trial 1 and your position in trial 2. However, your grade cash carries forward from one trial to the next. Grade Cash from Trading Your aim is to make as much money as you can. This depends upon how well you trade relative to the prices discovered by the market. In each trial you earn grade cash calculated as: 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 may be conducted over a number of independent trials and performance can be assessed in terms of your average rank across trials.

Original case 1999 OS Financial Trading System. Used with permission.