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

2. 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: taskforce@mit.edu

3. Fixed Income Trading Game and Tutorial 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

4. Fixed Income Trading Game and Tutorial 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

5. Fixed Income Trading Game and Tutorial Coupon Bonds PV = Present Value = price of bond today C t = Coupon at end of year t FV = Face Value = $100 r t = Interest rate for year t

6. Fixed Income Trading Game and Tutorial Zero Coupon Bonds 1-year maturity: 2-year maturity: 3-year maturity:

7. Fixed Income Trading Game and Tutorial 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

8. Fixed Income Trading Game and Tutorial Building Replicating Portfolio w 1 = Weight of 1-year zero w 2 = Weight of 2-year zero w 3 = Weight of 3-year zero C 1 = w 1 * 100 C 2 = w 2 * 100 C 3 = w 3 * 100 P Coupon = w 1 P 1-year + w 2 P 2-year + w 3 P 3-year

9. Fixed Income Trading Game and Tutorial Arbitrage Opportunity Price of replicating portfolio: P R Price of coupon bond: P C If P R < P C –Sell coupon bond, Buy the appropriate zeros If P R > P C –Buy coupon bond, Sell the appropriate zeros Buy low and Sell high

10. Fixed Income Trading Game and Tutorial 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

11. Fixed Income Trading Game and Tutorial The Bid-Ask Spread BID 158 1/8 Market maker buys Market taker sells ASK 158 7/8 Market maker sells Market taker buys

12. Fixed Income Trading Game and Tutorial 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

13. Fixed Income Trading Game and Tutorial 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

14. Fixed Income Trading Game and Tutorial Being the Market Maker Ask 90 91 Bid 80 79 Bid does NOT Make the Market Ask does NOT Make the Market MARKET

15. Fixed Income Trading Game and Tutorial 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.

16. Fixed Income Trading Game and Tutorial Trading Interface Security Names Traders in the FTS markets determine prices Individual endowments Seconds remaining for current trading period. You can borrow or lend at a variable interest rate Realized payouts displayed here

17. Fixed Income Trading Game and Tutorial 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