Question

Financial Markets 1. 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 $102.50. Suppose that 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? (Hints: It is possible to have negative inventory. Further, there is more than one correct way to value an inventory, but please state what assumption your valuation is based on.)

Answer 1

Answer:

$1,000; $613,500

Explanation:

Given that,

Quote a bid = $102.25

Bid ask = $102.50

(a) On Day 1,

Receive market buy orders = 10,000 shares

Market sell orders = 4,000 shares

Shares bought and sold = 4,000 shares

Spread = Bid ask - Quote a bid

            = $102.50 - $102.25

            = $0.25 per share (Dealer's margin)

For 4,000 shares,

Dealer will earn = Number of shares × Spread

                          = 4,000 × $0.25

                          = $1,000

 

Value of inventory at the end of the day:

= Inventory at the end of day 1 × Quote a bid

= (10,000 shares - 4,000 shares) × Quote a bid

= 6,000 shares × $102.25

= $613,500