Fixed Income Trading Game and Tutorial For SEBC May 8, 2004 Sanjiv Parekh

Fixed IncomeTrading Game and

TutorialFor SEBCMay 8, 2004

Sanjiv Parekh

Fixed Income Trading Game and Tutorial

Welcome

• Sloan Trading Room Task Force was established in 1997 by Prof. Andrew Lo.

• Trading room is used for research, trading games and simulations, and finance classes.

• Types of trading games include: equity, fixed income, derivatives, and foreign exchange.

• Information: http://mitsloan.mit.edu/trader

• Email Us: [email protected]


Agenda

• Today’s Game: – Zero coupon bonds and 10% coupon bond

• Bond Valuation

• Trading Mechanics: Bid-Ask

• Trading Interface

• Two Practice Games

• Questions and Answers

• The Final Game


Case Scenario

• Four Securities:– 10% coupon bond maturing in 3 years– 3 Zero coupon bonds maturing in 1, 2, and 3 years– Face value for all bonds is $100

• Two periods: Year 1, Year 2, and Year 3

• Variable interest rates

• Replication of coupon bonds with Zeros


Coupon Bonds• PV = Present Value = price of bond today• Ct = Coupon at end of year t• FV = Face Value = $100• rt = Interest rate for year t

)1)(1)(1()1)(1(1 321211

321

rrr

FVC

rr

C

r

CPV

1 32Year

1101010


Zero Coupon Bonds

)1( 1r

FVPV

)1)(1( 21 rr

FVPV

1 32Year

100

)1)(1)(1( 321 rrr

FVPV

1-year maturity:

2-year maturity:

3-year maturity:

1 32Year

100

1 32Year

100


Uncertainty

• Have to “guess” what future rates will be

• To prevent arbitrage, pricing between coupon bond and zero coupon bonds should be related

• Replicating Portfolio– Use zero coupon bonds to match amount and timing

of cash flows of the coupon bond– Should have the same price as the coupon bond– If not same price then arbitrage


Building Replicating Portfolio

• w1 = Weight of 1-year zero



• C1 = w1 * 100

• C2 = w2 * 100

• C3 = w3 * 100

• PCoupon = w1P1-year + w2P2-year + w3P3-year


Arbitrage Opportunity

• Price of replicating portfolio: PR

• Price of coupon bond: PC

• If PR < PC

– Sell coupon bond, Buy the appropriate zeros

• If PR > PC

– Buy coupon bond, Sell the appropriate zeros

• Buy low and Sell high


Trading Mechanics

• Traders who want to sell stocks at a certain price post an Ask

• Traders who want to buy stocks at a certain price post a Bid

• Only Market Makers have the ability to post Bids and Asks


The Bid-Ask Spread

BID

158 1/8

Market maker buys

Market taker sells

ASK

158 7/8

Market maker sells

Market taker buys


Stay Within the Spread

Ask

sell buy

159 160

• Do not trade outside the spread• Be the market maker with unsophisticated traders in the market

$$$ $$$

Bid

sell buy

159 160


Being the Market Maker

Ask

90

89*

Bid

80

81*

New Bid Makes the Market

(Market Maker)

New Ask Makes the Market

(Market Maker)

• Bid-Ask spread goes from 10 to 8 once the new bid and the new ask make the market

MARKET


Being the Market Maker

Ask

90

91

Bid

80

79

Bid does NOT Make the Market

Ask does NOT Make the Market

MARKET


Terminology

• Going Long: buy the bond– You think the bond price will go up

• Going Short: sell the bond– You think the bond price will go down– Selling more units than you have, known as short

selling, ends up with negative number of units.– In this game, you can short sell as much as you want– Have to cover short position at end by buying back

the bond. Done automatically in the game.


Trading Interface

Security Names

Traders in the FTSmarkets determine prices

Individualendowments

Seconds remaining for current trading period.

You can borrowor lend at a variableinterest rate

Realized payouts displayed here


Enter any trading name(at least 3 characters)

Type in the actual names of each trader on the team

Logging In

DO NOT PRESS CONNECT UNTIL ASKED TO DO SO

Documents

Fixed Income Trading Game and Tutorial For SEBC May 8, 2004 Sanjiv Parekh