Quote-Driven Market

The two most obvious are liquidity (banks and other financial institutions have regular required payments, thus holding instruments that can regularly be converted into cash is beneficial) and price volatility, as the price of short dated securities is less volatile and therefore this is less risky for institutions that have regular payments to make.

A quote-driven market is when the bid and ask quotes of market makers are available and any buyers or sellers go to these market makers and buy or sell in line with those quotes. In an order-driven market all the bid and ask quotes of any market participants are available and anyone can match any quotes for a trade to take place.

According the Capital Asset Pricing Model, the return of the share is given by the following formula: Rj = Rf + β * (RM – Rf) in this instance 5 + 1.1*10 = 16%.

According the Dividend Growth Model, the price is given by P = D1 /(K – g), where K is the required return on the share calculated in line with the CAPM.

In this case the fair price of the share should be P = 20*(1+0.06)/(0.16-0.06) = 212 pence or £2.12, so if it is trading at £2.50, they are overpriced, so your friend should sell.

The variables are:

Rj – required return on security j (also K)

Rf – return on a risk free investment

RM – return of the market portfolio (RM – Rf = market risk premium)

β – assesses the level of risk of the security relative to the market portfolio risk

D1 – dividend in period one (next period) which can be calculated as D0 * (1 + g), with D0 being the most recently paid dividend

G – growth rate of dividend