Teaching Guide
·
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 nonconstant 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
informationbased 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 1stock 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 stockbond 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 don’t have to run the cases “asis.”
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
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 SWseries 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.
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
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 onscreen 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
You can print out the instructions in this
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
markettakers.
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: TBills 
X 

Bond Quotations: TNotes 
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 

1Period 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 

MultiPeriod 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 