Teaching using a Trading Case Approach
A trading session is much like a class laboratory session in physics or chemistry. It provides the means for students to experiment with and experience important concepts discussed in the classroom. Students get to compete against each other in the market as a member of the trading crowd whose task it is to discover the prices of securities being traded. Each case is designed so that the price discovery problem is linked directly to the teaching objectives of the trading case.
The FTS Markets lets you run markets either locally or over the web. To run locally all you need are PC's connected together on your local network. To run over the web all you need is an externally visible IP address or name.
Running the First Two
Trading Sessions
Example based upon RE1
Overview
The objective of the first trading session is for students to become acquainted with the FTS markets and trading on the FTS system. The basic question addressed in this session is where do prices come from?
The objective of the second (and all other trading sessions) depends upon the teaching objectives associated with the case used. Once students understand where prices come from they can focus on the price discovery problem itself. In each trading case the price discovery problem is directly linked to the teaching objectives associated with the case.
Trading case RE1 is relevant for teaching market efficiency and the dividend model of stock prices. Students compete against each other in a dynamic market designed to let them become acquainted with the idea that prices are an important source of information. All data from the trading session is stored in an Excel spreadsheet and a replay module is available to provide a graphical replay of the market.
Teaching Objectives for RE1
Session 1: The objective is for students to understand from personal trading experience the question: Where do prices come from? This implies they must become familiar with the basic elements of a trading case, interacting with the FTS system (see below for the list of important features), and how to submit limit and market orders.
Elements of a Trading Case: Students are the trading crowd whose task it is to discover prices in the following setting. In RE1 trading takes place on day 1 of each of two years. At the end of day 1, year 1 time flashes by and the end of year dividend per share is realized. The market then opens for day 1 of year 2 and at the end of day 1 year 2 time again flashes by and then the final liquidating dividend per share is realized. This completes one trading trial and all positions are liquidated (i.e., marked to realized terminal payoffs) and converted to cash. Based upon the total cash at the end of the current trial each trader earns a trading bonus. A new trial can then be started. No position carries over to the new trial apart from each trader’s cumulative trading bonus. Conducting repeated independent trials permits the trading crowd to go down the learning curve for trading RE1.
For the very first trading session plan upon completing approximately 2-3 trading trials so you can address questions with the market paused.
Important Checklist for First Session
1. How to Log into FTS
2. Elements of the trading screen
3. Double Auction Market (Central limit order book is observable in the FTS market)
4. Submitting an Order/Trade (Limit and market orders)
5. Information (if relevant to the case e.g., RE1 has private information)
6. Trading support systems (double clicking on a security name to see the book, graphs etc., Optional: linking to Excel to bring in prices in real time and to have personal trading diary written out in real time)
7. The trading objective and earning the grade cash trading bonus.
The above are covered in the Fast Start to the FTS Trader.
Central Question
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. Some trader must enter a Bid to buy or Ask to sell some quantity of the stock. Second, some other trader must be prepared to sell to the Bid or buy from the Ask some quantity up to the amount available. In session 1 students should be encouraged to act as both market makers and market takers without worrying about what prices they transact at. The latter is the objective of trading session 2 when they come to class with the session 1 experience.
Session 2: Discovering Prices in RE1 and Interpreting
the Discovered Prices
In RE1 the application of the dividend model is not straight forward at the individual trader level. This is because each trader starts with some private information that lets them estimate the expected dividend each period from each stock. However, once the market opens, price also becomes a source of information which will influence a trader’s prediction of the future dividends. In particular, information is such that if price aggregates all information then price perfectly reflects the true future dividends. Otherwise price is a noisy source of information. RE1 is constructed such that it is likely that price is noisy in period (day 1, year 1), but as the trading crowd becomes experienced (with independent trading trials) price is likely to reveal the information in period 2 (i.e., day 1, year 2).
In period 1, a common error students initially make is to ignore the fact that the stock has a two period life. That is, in period 1 they will value the stock at the expected value of the first period dividend only. It is better not to point this out until after the actual trading session because the better traders will arbitrage the weaker traders.
RE1 Solution
In RE1 the market as a whole has perfect information because the information provided to all traders allows elimination of all but one event. For example, suppose you have the clue Per. 1 Not y and some other trader has Per. 1 Not x, the market as a whole now knows that in Year 1 the realized event is z. The issue is whether this aggregate information can be revealed by price by trading.
Suppose the market as a whole knows that in Year 1 the event is z and in Year 2 the event is z for ABC. The strong form efficient market value of the share is unambiguous. In Year 1 this is (24 + 24 = 48), and in Year 2 this is 24. The risk free rate of interest is zero, so no discounting is required. However, the point of the RE series is whether price can aggregate information.
If price fails to aggregate information in this market then at the other extreme traders may rely solely upon information that is available prior to the trading period starting. This is sometimes referred to as the prior information equilibrium and is consistent with the semi-strong form of the efficient markets hypothesis. In this current example, competition among trader types with the highest prior expected value will push price up to this expected value (if the market behaves as if it is risk neutral).
In the current example in period 1 if the market as a whole knows the realization to be z, z but the set of all possible trader types have only imperfect information, then information is distributed as follows:
Type I: not x, not x Period 1 Expected value: 18 + 18 = 36
Type II: not x, not y Period 1 Expected value: 18 + 15 = 33
Type III: not y, not x Period 1 Expected value: 12 + 12 = 24
Type IV: not y, not y Period 1 Expected value: 12 + 12 = 24
The prior information solution for this example is 36 in period 1 because of the assumed competition among Type I’s.
At the beginning of period 2 in this example the period 1 realized value is publicly known to be z and so the possible prior information prices in period 2 is the Max{24, 18} = 24.
Possible Variations
to the Standard RE1: In the default
RE1 the risk free rate is zero and so the opportunity cost of capital is zero
(if the market is strong form efficient).
However, you can easily introduce a positive risk free rate for the real
trading session (i.e., session 2) by bringing up the support RE1 case
spreadsheet and changing cells G21 to G36 from 0 to the risk free rate of your
choice. You can also see that it is easy
to make period 2’s risk free rate stochastic by linking these cells to a
formula involving Excel’s
Using FTS Trading
Cases in Other Sessions
The set of trading cases provided with the Financial Trading System (FTS) provide large sets of ready-to-run Trading Exercises. There are four core strands that can immediately be followed.
A. Efficient markets and equities
B. Fixed income, forwards and theories of the yield curve
C.
Forward
Pricing and the Cost of Carry Model
D. Option pricing theory
E. Risk management
Core Strands
A. For this strand the set of relevant cases consist of the dividend model/efficient market cases RE1-RE5. Portfolio theory CA0, and CAPM CA1-CA5.
B. For this strand the set of relevant cases consist of B01-B08. This permits the time value of money, spot rates, forward rates, spot contracts and forward interest rate contracts to be taught. In addition, future spot rates can be stochastic and private information about future spot rates is present in some cases. The latter are the fixed income case equivalent of RE1.
C. For this strand the set of relevant cases consist of IN1/2 (an introduction to stock index futures without and with private information), FX1/2 (forex trading and covered interest rate parity) B03, B03A (Interest rate forwards without and with private information and uncertainty).
D. For this strand there is RE3 (an introduction to options and option trading strategies), OP1-OP7 binomial option pricing cases, static hedging OP8, continuous time option trading cases ST1, ST2, XR1, and XR2.
E. For this strand the set of cases cut across A-C. This set consists of diversification CA0, duration and hedging interest rate risk BO4, reducing borrowing costs using interest rate derivatives to form a synthetic loan, RM1, stock index futures and borrowing constraints, CA4 and CA5, delta hedging in a binomial world OP3, and applying “the Greeks” ST1, ST2, XR1, and XR2.
It is easy to construct your own cases and or variations of the above cases. Keep in mind that often it is only the framing of the case that is important for a particular course. That is, usually the underlying generic structure is common but the case description, the security name/description etc., needs changing to suit a particular course. This is easily done via the labels etc., in the case Excel spreadsheet. If help is required on this front email fts@ftsweb.com.