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Teaching Guide

 

Overview

·         The FTS Interactive Market is a trading simulation designed to build the conceptual, analytical and modeling skills of students. 

·         Students trade with each other in a true market, experience the dynamics of a dealing room, and gain a deeper understanding of how financial markets work.

·         The program trading capability lets students develop and experiment with trading strategies that go far beyond manual trade entry systems and let them experience how today’s financial markets work.

In an FTS Interactive Market, students trade with each other and learn by doing.  They learn not only from their own experience but the experience of others.  What they trade depends on the “trading case” you choose; we offer over thirty cases, and you can easily create your own cases as many instructors have done.  What they learn is not only the mechanics of how financial markets work, but also how to apply concepts of valuation, diversification, hedging, and risk management in a real time competitive environment.  Preparing and participating in the trading cases helps develop their analytical and model building skills.  You choose the subset of cases that are most relevant to your course.

 

The mechanics they learn include:

·         The trading process: bidding, asking, making and taking market

·         microstructures: double auctions, quote and order driven markets, market makers

·         limit orders, short sales

 

The concepts they learn include:

·         price discovery

·         time value of money

·         interest rate risk management

·         market efficiency

·         diversification

·         risk premiums

·         arbitrage

·         option pricing and hedging

·         futures pricing and hedging

·         covered interest parity

 

The system allows student to link market data in real time to an Excel worksheet.  This lets them develop their modeling (and Excel) skills by building a support system.   They can even create computerized trading strategies and have the different strategies complete with each other.

 

They also learn something beyond the textbook, something that can only be experienced: the dynamics of a marketplace, the real time reaction of traders to information and the actions of others, and how the nature of the financial instruments being traded, information, and attitudes toward risk, all come together in the price discovery process that is a central function of markets.

 

The trading cases: the standard FTS cases are here.  The Student Case Preparation Manual shows students how to prepare for trading and includes building an analytical support system that not only reinforces the theory but also develops their modeling skills in Excel (it also contains notes for instructors).

 

Operational details

The markets are very easy to run, summarized in this QuickStart Guide.  The instructor (or TA or lab assistant, more generally the “moderator”) runs the “FTS Market” software from the FTS System Manager (after logging in as a moderator), selects the case, and lets the students connect to the market.  Each student runs the “FTS Trader”, and connects to the market (they need to know the IP address of the moderators computer). 

 

The moderator starts the market and trading can begin. Information is sent out as specified in the case (at the beginning or during the trading).  At the end of the trading, various types of settlements occur, again depending on the case (dividends and/or coupons are paid; options and futures are settled; etc.). 

 

The trading case is repeated as desired; the repetition lets students understand more deeply the nature of the securities, the valuation problem at hand, and the application of the relevant concepts.

 

At the end of each repetition (which we call a “trial”), a detailed summary shows each student where they made or lost money: in aggregate as well as by individual securities.  They also see how they did relative to others, including their rank.

 

All trade activity, market values, and ranks are stored in a spreadsheet on the moderator’s computer.

 

Practicing with the system

Students can practice with the system at any time.  We run a demo of the FTS Market (trading case B02) all the time.  Students run the FTS Trader and click the “connect to demo” button.  In the demo, we feed in actual data from a previous run to play the role of other traders.  Students can bid, ask, buy, sell, and otherwise learn the mechanics of the trading system.  This lets them become familiar with the technology and allows them to focus on the conceptual problems in a real trading session.

 

The Trading Cases

The most commonly used trading cases are described here; the full list is at the case website.  We also have specialized cases (such as the teaching of ethics) which are available on demand.  At the end of this document, we list the concepts covered by the cases in tabular form.

 

Fixed Income Cases

 

·         B01 A simple time value of money case.  Students trade a coupon bond and a zero coupon bond in a in a constant interest rate world lasting three periods.  The key concepts include understanding discounting and applying it to bond valuation.

·         B02 An extension of B01, with coupon and zero coupon bonds but with non-constant interest rates.  Besides reinforcing the discounting and bond valuation, the case can also be used to introduce cash matching and arbitrage.

o    B02A is an extension of B02 with uncertain interest rates and information about interest rates, and allows for a discussion of the determination of yield curves.

·         B03 introduces forward markets into B02, and so focuses on forward pricing as well as concepts of arbitrage

o    B03A introduces uncertain interest rates into B03, and introduces hedging with forward contracts

·         B04 has uncertain yield curves and focuses on using duration and convexity to manage interest rate risk

o    Advanced fixed income cases include B05 and B06 (introduction to interest rate trees), and GC1 (with a more general structure of interest rate uncertainty and information)

 

Market Efficiency Cases

 

·         RE1 introduces students to how markets aggregate information.  Individuals are given private information about the prospects of firms and can trade on the basis of this information.  The question is whether prices “reflect” all available information

·         RE2 is an extension in which payoffs are correlated in more complex way, so information about one firm can provide information about another firm

·         RE3 introduces options into a market with private information.  This allows the use of information-based option trading strategies and can have very strong effects on price discovery.  You can also see if the option market leads or lags the spot market.

o    Note: the RE case spreadsheet also contains: a 1-stock version of RE1 with and without private information and as a double auction, a quote driven market, and an order driven market, and also quote driven and order driven variations of RE2.

 

Diversification Cases

 

·         CA1 is our main case on the pricing of risky cash flows.  The market determines the prices and therefore the risk premiums of three correlated stocks.  The outcome can be related to the CAPM, including the construction of the “market portfolio.”

·         CA2 is CA1 but with exogenous prices, the problem, as in CA0, focusing on diversification without the complexity of price discovery.  Together, CA1 and CA2 let students understand the price discovery and asset allocation problems in a world with risky cash flows.

·         CA3 is a variation of CA1 in which traders are rewarded for taking risk.  This case illustrates how risk preferences affect prices and thus risk premiums.

o    GC2 is a stock-bond trading case; it contrasts the pricing problem for fixed income securities versus stocks.

 

Option Cases:  Binomial Option Pricing

 

·         OP1 is the one period binomial model, focusing on option pricing; provides an introduction to options, synthetic replication, risk neutral valuation and put call parity. 

·         OP2 is a two period version of OP1 with American options.  Introduces dynamic replication

·         OP3 is a three period version of OP1 but designed around a delta hedging.

o    OP4 to OP9 are extensions, of OP1 to OP3, some have information about the underlying, some have price discovery in both the underlying as well as the options.

 

Option Cases: Continuous Time

 

·         ST1 focuses on delta hedging in a Brownian motion world with exogenous prices for stocks and options

·         ST2 is ST1 but  with price discovery for options

·         XR1 introduces currency options, and the students have to manage currency risk using option trading strategies.

·         XR2 extends XR1 but has jumps in the underlying, and so simulates exchange rate crises.

 

 

Forward and Futures Cases

 

·         IN1 has stock index futures and focuses on the cost of carry model. 

·         IN2 extends IN1 with information from analyst’s forecasts.

·         FX1 is the main case for currency forwards and teaching covered interest parity

·         FX2 extends FX1 to include private information.

o    FX3 introduces triangular arbitrage and can also be used for covered interest rate parity

o    FX4 is the extension of FX3 with private information

 

Swaps

 

·         SW1 introduces swap markets with real world day count conventions with competing swap desks; we also have SW1NoDayCount which is the same with fixed period lengths.

·         SW2 extends SW1 to the case of news and information about interest rates, and you can also run this abstracting from day count conventions.

o    SW0NoDayCount introduces swap trading abstracting from day count conventions).  A follow on case, SW0NoDayCountInfo has with privation information about interest rates.

 

 

The Advanced Risk Management Case

 

·         RM1 is an advanced risk management case based on constructing synthetic fixed rate loans using forward rate agreements, interest rate caps and floors.  It serves as a capstone case for advanced corporate finance courses, derivatives courses, and risk management courses.

 

 

Teaching Suggestions

You can teach at different levels.  At the base level, the system serves as an introduction to “what happens in a stock exchange” or “where do prices and interest rates come from.”  At a second level, it serves as a way to think about cash flows and valuation of securities.  At a third level, it lets students develop their own analytics in Excel to support trading.  You can easily vary the trading cases so that each run is different and so the analytics matter.  At a more advanced level, students can learn to develop trading algorithms and see how their algorithm performs compared to human traders as well as to the algorithms of others.

 

You don’t have to run the cases “as-is.”  They are easy to modify (the entire case is specified in an Excel worksheet).  We have included some teaching suggestions and variations in the student manual.

 

Introductory finance courses

In an introductory finance course, such as “Financial Markets” or “Financial Management: we suggest running the following cases:

·         B01 to introduce students to the system

·         B02 to teach the time value of money

·         RE1 when discussing market efficiency

·         RE2 to further their understanding of markets, price discovery, and information

·         If you teach forwards and futures, we suggest using B03

·         If you teach options in the course, then we suggest OP1 and OP2

 

Corporate finance courses

In corporate finance courses, we suggest

·         B01 if this is a first finance course

·         B02 to review discounting and time value of money, with variations as described in the student manual

·         CA1 to help understand diversification and risk adjusted return

·         OP1 and OP2 when options are introduced

·         If you teach corporate hedging, then you can use B03 to introduce interest rate forwards, and then IN1 to introduce equity futures and FX1 to introduce currency futures

·         If you teach swaps, then the SW-series introduces the swap markets

·         Finally, in an advanced corporate finance course, you can use RM1 to bring together many aspects of a realistic corporate risk management exercise.

 

Investments courses

In an investments course, usually taken after an introductory finance or corporate finance course, we suggest

·         Starting with B01 and B02 if a review of time value of money is needed

·         B04 when discussing bond immunization

·         Continuing with RE1 and RE2 to discuss market efficiency

·         Moving on to CA1 and CA3 to discuss diversification, risk preferences, and the pricing of risky cash flows

·         IN1 and IN2 when discussing futures

·         OP1, OP2, and OP3 for binomial option pricing and hedging

·         ST1 and XR1 when discussing option pricing and hedging

·         Any of the SW series if you cover swaps

 

Derivatives courses

You can teach both introductory and advanced courses focusing on derivatives.  We suggest

·         Starting with case B03 to reinforce forward pricing

·         Continue with IN1 and IN2 (equity futures)

·         Then use FX1 and FX2 (currency futures)

·         Use SW1 for swaps

·         For the options component, start with OP1 and OP2, then OP3

·         Move on to ST1 and XR1, and use XR2 to introduce jumps in the underlying

·         In an advanced course, end with RM1 to bring together swaps, caps and floors to solve a corporate risk management problem

 

Financial Modeling courses

·         The system provides an exciting dimension to modeling courses.  The goal here is to create a model in Excel, enhance it to provide trading signals, and going further, to develop algorithmic trading strategies. 

·         The strategies can be created using VBA (or by creating a DLL in a programming language and calling it via VBA). 

·         To get students to experience a variety of asset classes, we suggest using the following cases:

·         Start with B02, B03, and B04

·         Move on to RE1 and RE2, where thinking about the trading support and strategy is not quite as simle

·         Use the OP series to reinforce binomial option pricing

·         You can use IN1 and IN2 as well as FX1 and FX2 for equity futures and currency futures.

 

 

Running a trading session

 

In the first session, we recommend using a simple case such as B01 or RE1 to let students become familiar with the system.  In that session, the instructor or moderator will

·         Log in to the FTS System Manager as a moderator

·         Run the FTS Market

·         Select the trading case, and follow the on-screen instructions and allow students to connect.

o    The students will need to know the IP address of the moderators computer

·         After the students have connected, start the trading session

 

The steps required are spelled out step-by-step on the page “Running a Market.”  You can also print out a PDF file of  Quick Start Instructions.”   These instructions also contain the student instructions for launching the software.  

 

Students will need to learn:

 

·         How to run the FTS Trader

·         How to connect to the market being run by the instructor

·         Elements of the trading screen (described in the student manual)

·         How to trade

o    Submitting bids and asks

o    Accepting bids and asks placed by others

·         The trading objective and the “grade cash” that is earned, as described in the case

 

In more advanced cases, they will need to learn:

·         How to view information

·         How to link the trading screen to an Excel workbook

 

When you start the trading, there are no prices.   You may be asked:  how can we trade when there are no prices? This is often the first time students realize that for a trade to take place two things must happen.  First, someone must enter a bid (offer to buy) or ask (offer to sell) to sell some quantity of a security.  Second, some other trader must be prepared to accept the bid (sell to the bidder) accept the ask (buy from the asker) a quantity up to the amount offered.  In an initial session, students should be encouraged to submit bids and asks (act as market makers or dealers positing quotes) and also accept the bids/asks posted by others (and so act as market-takers.

 

All data from the trading session is stored in an Excel spreadsheet. A replay program is available to provide a convenient and graphical replay of the market.

 

At the end of the trading, a summary window lets each student see where they made and lost money, by security as well as in aggregate.  At this point, you repeat the sessions (since several repetitions are usually needed for students to fully understand the nature of the problem).  At the end, you can present the solution, as given in the “Case Solutions.”  The solution manual also provides some teaching tips for each case.


Teaching Interactively

The markets provide a unique way to for the instructor promote student learning. In the FTS interactive markets, students in a variety of ways: from the case preparation (connecting concepts to markets), and also from experience: their own as well as that of others.  So you can get situations where students who do not understand a concept or how to apply it are at a disadvantage in the market.  For example, suppose the theory implies that a security price should be no less that P, but someone does not “get it” and they sell at a price below P.  When this happens, or more generally you see behavior that shows someone does not get it, click the Pause button on the market.  Get everyone’s attention and point out the issue, in this case why the price should be no less than P.  You can step through the concept explaining why the price should not be below P.  Even better, you can have students tell you what they think is the issue, and why, and then review the concept.  Then resume the market and you will see the learning take place.

 

You also don’t have to run the cases as specified.  You can easily change them and create your own.  For example, one of our simplest cases, B01, has fixed interest rates and no uncertainty.  So in theory, there should be no trading: everyone should be able to perform the discounting, come up with exactly the same price for the bonds in the case.  In practice, this does not happen: not everyone does it correctly, at least initially.  But when they do converge and there is no more trading, you can actively change the environment, for example, by changing interest rates or by announcing that rates will change in the future (and then changing them at the correct time; simply enter the new rate before you start that period).  You can also move to a different case within the class period, such as B02 and the B02A (which has uncertain interest rates).

Some of the most exciting cases are RE1, RE2, and RE3, which deal with market efficiency.  These cases are a live test of whether prices aggregate or reflect or reveal private information, and so every run is usually different.  Here, pausing the market and letting students explain their understanding of how price discovery and information revelation can be very interesting given the importance of the concept in finance.  You can broaden the discussion, for example, to implications for insider trading.  You can even run variations, such as turning off the ability to view the limit order book and see its impact of efficiency.  You could run a call market and compare it to the outcome in a double auction.

Concepts covered by cases

 

BO1

BO2

BO2A

BO2R

BO3

BO3A

BO4

BO5

BO6

Opportunity Cost of Capital

X

X

X

X

X

X

X

X

X

Arbitrage

X

X

X

X

X

X

X

X

X

Price Discovery

X

X

X

X

X

X

X

X

X

Time Value of Money

X

X

X

X

X

X

X

X

X

Future Spot Rates and Bond Prices

X

X

X

X

X

X

X

X

X

Price and Spot Rates by Maturity

X

X

X

X

X

X

X

X

Cash Matching

X

X

X

X

X

X

X

Trading Forward Rates

X

X

X

X

Synthetic Security

X

X

X

X

Interest Rate Uncertainty

X

X

X

X

X

X

Bond Quotations: T-Bills

X

Bond Quotations: T-Notes

X

Private Information/ Market Efficiency

X

X

X

X

Public Information/Fixed Income Market Efficiency

Term Structure of Interest Rates

X

X

X

X

X

X

X

X

Duration and Convexity

X

 

RE1

RE2

RE3

CA0

CA1

CA2

CA3

Dividend Model

X

X

X

X

X

X

Efficient Markets Hypothesis

X

X

X

X

X

X

Arbitrage and Efficiency

X

X

X

X

X

Diversification

X

X

X

X

CAPM- Trading in a Risk Averse World

X

X

X

CAPM- Trading in a Low Risk WORLD

X

Intrinsic Value: Abnormal Growth Model

X

X

X

Impact of the Yield Curve on Stock Prices

X

X

X

 

SW1

RM1

Financing Decision

X

X

Libor

X

X

Variable Rate/Fixed Rate

X

X

Swaps

X

X

Risk Management

X

X


 

IN1

IN2

FX1

FX2

XR1

XR2

BO3

XR1

XR2

Cost of Carry Model and Synthetic Forwards

X

X

X

X

X

X

X

Forward Price versus Forward Value

X

X

X

X

X

X

X

Arbitrage Pricing

X

X

X

X

X

X

X

 Basis, Contango and Backwardation

X

X

X

X

X

X

X

Arbitrage and the Bid/Ask Spread

X

X

X

X

X

X

X

Hedging Fundamentals

X

X

X

X

X

X

X

Interest Rate Forwards

X

X

Stock Index Forwards/Futures

X

X

Currency Forwards

X

X

X

X

Currency Futures

X

X

Covered Interest Rate Parity

X

Interest Rate Risk

X

Informational Efficiency and Forward Markets

X

X

Futures and Marking to Market

X

X

 

OP1

OP2

OP3

OP4

OP9

ST1

ST2

XR1

XR2

RE3

Information and Option Trading Strategies

X

1-Period Binomial World

X

X

Synthetic Option (Put/Call)

X

X

X

X

X

Put Call Parity

X

X

X

X

X

X

X

X

X

X

Risk Neutral versus Empirical Probabilities

X

X

X

X

X

Exogenous Underlying Price

X

X

X

X

X

X

X

X

X

Simultaneous Price Discovery in the Underlying

X

Risk Management Objective

X

X

X

X

Multi-Period Binomial World

X

X

American Options

X

Delta Hedging

X

X

Black Scholes Model

X

X

X

X

Applying the "Greeks"

X

X

X

X