TRADING CASE B05
Zero-coupon bonds and an interest-rate tree
LEARNING OBJECTIVE
Learn how expected future short-term rates can be used to value short-maturity zero-coupon bonds.
KEY CONCEPTS
Term structure | Interest-rate risk | Expectations | Risk premium
HOW THE CASE WORKS
You trade three zero-coupon bonds that mature in one, two, and three months. Trading takes place on Day 1 of each month. After each session, interest and maturing bond payments are added to or charged against your cash.
BOND PAYMENTS
| Bond | Month 1 | Month 2 | Month 3 |
|---|---|---|---|
| GKO-1 | 100 | 0 | 0 |
| GKO-2 | 0 | 100 | 0 |
| GKO-3 | 0 | 0 | 100 |
INTEREST RATES
The first one-month rate is 6.5% (not annualized). At the start of Month 2, the next one-month rate can be 5%, 9%, or 11%, with equal probability. Later rates follow the case's interest-rate tree.
TRADING RULES
- You may buy or sell any of the three bonds.
- Students set prices by entering bids and asks.
- Borrowing and short selling are allowed.
- An open short position must make the bond's payment at maturity.
AFTER TRADING CLOSES
The realized one-month rate is applied to closing cash.
Any bond maturing that month pays 100 to a long holder or charges 100 to a short holder.
The next month's market then opens.
PERFORMANCE: Trading bonus (grade cash) per trial = 0.0001 x closing market cash. Positive wealth adds grade cash; negative wealth subtracts it. Results accumulate across independent trials.