Here is the background information on your task
The difference between where a trader feels its risk can be hedged and the price to the client is the “market-making spread”, usually quoted in a format known as a “bid/offer spread”.
A bid represents where a client can sell an asset, while offer represents where they can buy. The average of the bid and offer price is often referred to as a “mid” rate, and represents the current market price for an asset.
Bid and offer – the spread from current mid – can represent many things, but is best described as the premium a trader needs to manage associated risk. If markets are less liquid or a trade is larger in size, we’d expect that spread to be wider.
Example: Investor seeks to take a short position in Tiger Corp
Jack (the client) is a hedge fund analyst who believes that the recent Coronavirus crisis will hurt Tiger Corp’s earnings more than the market believes. Jack has been in touch with Mary, his JP Morgan equity sales representative, to better understand market dynamics. Mary has sent several trade ideas, one of which is simply an equity future to sell the equity in 3 months’ time following the company’s earnings report. Today, he’s ready to trade.
Jack communicates to Mary he wants to sell 500 shares in 3 months via a futures contract, as Mary had pitched to him. Mary asks Donna (the trader) where she would be able to trade that on Jack’s behalf. Donna offers a price of $21/per share and notes that the mid price is $22/share. Mary flags that a $1 spread is wider than she would normally see, and Jack had received indications that it would be closer to 75 cents.
Mary: “I thought we communicated a spread of closer to 75 cents?”
Donna: “The size is larger than I was expecting, and given it is a summer Friday, liquidity is challenged. This would be my best.”
Mary: “Hi Jack – we can currently get done at $21/share”
Jack: “That looks a little off from what I am seeing – I was expecting closer to $21.25-$21.50”
Mary: “Liquidity is pretty challenged, especially on a Friday afternoon in August”
Jack: “Is there any room to improve?”
Mary: “This will be our best”
Jack: “Ok, we can be done”
Here is your task
There are two parts to this task. Please prepare your answers to both parts in a word document.
Given the background information and the scenario above, please select the best answer in the following Multiple Choice questions.
Q1: Bid/offer can be defined as:
a. A market participant’s desired level to buy or sell an asset
b. A general range of where a specific security/derivative might be trading
c. A market marker’s price for a participant to sell or buy a security/derivative relative to the current mid-market price
d. A technical level that a market maker thinks is a key price to reach
Q2: Which of the following factors may lead to a widening of bid/offer?
a. Stressed market conditions in times of crisis
b. Plenty of market participants looking to buy/sell a security/derivative
c. Overlap between two global region’s trading windows, leading to more market participation
d. Directional markets – the market is looking to either buy or sell, but not both
e. A & D
f. B & C
Q3: True or False: When a market maker provides his bid price for a certain stock, it is for a client to purchase the stock
Please prepare a short paragraph (~200 words) to elaborate on how liquidity—using bid-ask spread as an indicator—can be affected by the macroeconomic factors mentioned in the scenario described in the Tiger Corp example.
We recommend you spend 30-45 minutes on this task.
Resources to help you with the task
We suggest you look at Futures 101 for this task.
Clients could hedge their equity trades with futures, which can be executed with J.P. Morgan’s F&O desk and cleared through Global Clearing. A futures contract is an agreement to buy or sell for a:
- Standard quantity
- Specific underlying asset
- Fixed date in the future
- Price agreed today