Objects Traded in the IEM
The IEM trades futures contracts in which the ultimate values of the contracts are determined by political events, financial events and economic indicators. Each contract to be listed on the IEM is defined in terms of a name (to uniquely identify the contract), a "fundamental" on which the contract is based, an expiration date, and a liquidation value. The fundamental consists of some statistic or set of statistics which can be objectively measured, and the liquidation value will depend upon the value of the fundamental on some pre-specified date. Typically, each contract will be part of a set of contracts, and all contracts in a set will be based on the same fundamental.
For example, the Computer Industry Returns Market uses one-month relative common stock and index returns as the fundamental. Each month, four contracts trade from the Monday after the third Friday of the month until the Monday after the third Friday of the next month (when they expire). Expiration months are designated in each contract's name with "a" representing January, "b" representing February through "l" representing December. Contracts expiring in month "m" are:
- AAPLm associated with Apple Computer Common Stock
- IBMm associated with IBM Common Stock
- MSFTm associated with Microsoft Common Stock and
- SP500m associated with the S&P500 market index.
The determination of contracts listed on the IEM is made by the IEM Governors. Details of the contracts will be specified in a prospectus issued before trading in the contracts commences. Those prospectuses will appear on the IEM website (tippie.uiowa.edu/iem).
Contracts are issued by means of "unit portfolios." A unit portfolio consists of one of each of the contracts in the market and has a price equal to the guaranteed aggregate payoff of this contract set. In this way, the IEM neither gains nor loses money by issuing contracts.
Contracts are placed in circulation by traders through the purchase of these unit portfolios from the IEM. Similarly, contracts can be withdrawn from circulation through the sale of a unit portfolio to the IEM. The price at which these unit portfolios can be purchased or redeemed is determined by the sum of the liquidation values of all the contracts in the portfolio. Note that because contracts can be placed into or removed from circulation only by the purchase and sale of unit portfolios, there will always be an equal number of each contract in a set in circulation at any point in time.
For example, a unit portfolio for month "m" in the Computer Industry Returns Market consists of one of each of the four contracts AAPLm, IBMm, MSFTm and SP500m. The purchase or sale price of each of these unit portfolio is $1.00, which equals the sum of the liquidation values for one share each of AAPLm, IBMm, MSFTm and SP500m, regardless of which has the highest return in month "m"
Trading in a contract will cease on the expiration date as specified in the prospectus for that contract. At that time, or as soon thereafter as the value of the fundamental can be determined, liquidation values will be computed, the cash accounts of traders will be credited by the amount of the liquidation values of all expired contracts they hold, and those contracts will be removed from their portfolios.
For example, the fundamentals in the Computer Industry Returns Markets are determined on the third Friday of each month. Each month, the IEM computes the dividend adjusted rate of return based on closing stock prices of the underlying listed firm from the third Friday of the previous month to the third Friday of the expiration month. For these purposes, we will use closing prices as reported in the Midwest edition of the Wall Street Journal.
The Dividend Adjusted Rate of Return is calculated as follows: First, we compute the raw return on the underlying stock (the closing price on the previous third Friday minus the closing price on the expiration Friday plus any dividends on ex-dividend dates). Then, we divide the raw return by the closing stock price on the previous third Friday to arrive at the dividend adjusted rate of return. For the market index, we compute the capital gains rate of return by subtracting the closing index value on the expiration Friday from the closing index value on the previous third Friday and then dividing by the closing index value on the previous third Friday. Trading ceases on the following Monday, when existing contracts are liquidated and new contracts open for trading. Liquidation values are credited to the accounts of the traders holding the associated contracts.
Assume that IBM closes at $104.75 on the third Friday of month "m" closed at $100 on the third Friday of the previous month and paid a $0.25 dividend during the month. Then, the dividend adjusted return for IBM is: R = ($104.75+$0.25-$100)/$100 = 5%.
Suppose further that IBM has the highest such return among Apple, IBM, Microsoft and the S&P500 (where the S&P500 return is not dividend adjusted). Then, the liquidation value of IBMm contracts will be $1 and all other contracts will be $0.
If trader, Jack Jones, has $12.50 in his cash account and holds 4 contracts in IBMm and 2 contracts in MSFTm, then when these contracts are liquidated, $4 in liquidation values will be posted to his cash account giving him a total of $16.50.
For additional information about the Computer Industry Returns Markets, see the prospectus at: www.biz.uiowa.edu/iem/markets/pr_compu.html.