Teaching Guide

Overview

In an FTS Interactive Market, students trade with each other and learn by doing. 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 most importantly, how to apply concepts of valuation, diversification, hedging, and risk management in a real time competitive environment. 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

They also learn something beyond the textbook: 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.

Operational details

The markets are very easy to run. 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 standard trading cases we supply are described here. 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.

· 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

· B03A introduces uncertain interest rates into B03, and introduces hedging using forward contracts

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

· 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

· CA0 provides an introduction to managing risk and return of a position. Prices are given so the problem is to trade to a position on the efficient frontier

· 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.

· 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.

· 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.

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

· FX4 is the extension of FX3 with private information

Swaps

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

· 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.

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.

Pure Exchange Economy Cases

· We also have cases designed for economics cases, including pure exchange economies with Cobb Douglas preferences, and cases with a monopolist.

Teaching Suggestions

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

· 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

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 in the “Quick Start Instructions.” These instructions also contain the student instructions for launching the software. Detailed instructions are in the “Instructor’s Moderator Manual” which is available through the FTS System Manager once you log in as a moderator.

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.

Concepts covered by case

	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