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?

Answer 1

a) $1000 profit, inventory at end of day 1 is $613,500 using bid price and $614,250 using average of ask and bid price.

b) $48,000 loss and value of inventory is zero.

c) The market makers is a company or individual who quotes buy and sell price in an instrument to make profit. Their objective is to provide an opportunity to make a trade in the market. They help investors to buy or sell securities easily in the market.

The profit was earned by the difference of $0.25 in bid and ask price. This profit was minimized by keeping the securities in the inventory on day 1 and the prices went up on day 2. Market maker could have filled some more buy orders on day 1 to improve profits on day 2.

Step-by-step explanation:

a) Cost of buying 4000 shares :

4000 shares * 102.25 = $409,000

value of selling 4000 shares :

4000 shares * 102.50 = $410,000

Net profit = $410,000 - $409,000

= $1000.

Value of inventory at day 1:

10,000 shares bought - 4000 shares sold = 6000 shares left in inventory

6000 shares * 102.25 = $613,000.

b) Bought 8000 shares at 110.25

= $882,000

Sell 2000 shares at 110.50

= $221,000

Profit / Loss at day 2 = $221,000 +$613,000 - $882,000

= -48,000.

The ending inventory at day 2 is zero because purchase of 6000 shares on day 2 offset short position of day 1.