You are among the OTC market makers in the stock of Bio-Engineering, Inc. and qu

Question

You are among the OTC market makers in the stock of Bio-Engineering, Inc.
and quote a bid of 102.25 and an ask of 102.5. Suppose you have a zero inventory.
a) On Day 1 you receive market buy orders for 10,000 shares and market sell orders for 4,000 shares. How much do you earn on the 4,000 shares that you bought and sold? What is the value of your inventory at the end of the day?

b) Before trading begins on Day 2 the company announces trial testing of a cure for acne in mice. The quoted bid and ask jump to 110 1/4-1/2. During day 2 you receive market sell orders for 8000 shares and buy orders for 2000 shares. What is your total profit or loss over the two-day period? What is the value of your inventory at the end of Day 2?

c) What is a market maker's objective? Is there anything you could have done during Day 1, consistent with a market maker's objective, that would have improved your performance over the two-day period?

Explanation / Answer

The buyer states what price they will pay for the stock – this is the bid price. The seller also has a price – the ask price. You will notice that the bid price and the ask price are never the same. The ask price is always a little higher than the bid price. What this means is if you are buying the stock you pay the ask price (the higher price) and if you are selling the stock you receive the bid price (the lower price). Now with above info, lets see the solution :- a. Spread is 102.50 - 102.25 = 0.25 per share which is dealers margin. So for 4000 shares bought & sold, the dealer will earn 4000*$0.25 = $1000 Inventory at end of Day 1 is 6000 shares bought = 6000*$102.25 = $613,500 b. Day2 spread is still $0.25 ie 110.50 - 110.25 = 0.25 2000 Shaes will be bought @110.25 for 2000*110.25 = $220,500 6000 Shares are in inventory from Day1 bought at $613,500 ------------------------------------------------------------------------ Total Book value of 8000 shares = $834,000 ---------------------------------------------------- On Sale of 8000 shares, you will get 8000*110.50 = $884,000 So Profit on Sale of 8000 shares = $884000-$834000 = $50,000 Inventory is NIL c. Market makers objective is to minimize his loss & maximise his gains. Market maker could have tried to sell more shares to reduce his inventory. On 2000 Shares, the profit = Spread

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