Trading Case B02

The yield curve is important to every financial market. In this case you will gain experience with how the yield curve is determined.

Time value of money, the yield curve, arbitrage relationships, and cash matching.

Initially in this case there are four bond markets open for trading covering up to three years of calendar time. In particular, there are three zero coupon bond markets with lives equal to 1-, 2-, and 3-years and one 3-year coupon bond. Bond markets are open for trading day 1 in each of three years. The first trading period is day 1 year 1 and at the end of this period time flashes by and end of year settlements are executed (e.g., interest accrued or owing is settled, coupon payments are received (or made on any short coupon bond positions), and the 1-year zero coupon bond is settled). Shortly after this the market opens for trading period 2 which corresponds to day 1 year 2. At this time there are only three remaining bond markets open. The 1-year zero coupon bond that was open in year 1 has matured. However, the 2-year zero coupon bond from year 1 now has one year of remaining life. The 3-year zero now has 2-years of remaining life and so there are only three markets open for year 2. Again at the end of this trading period, time again flashes by and end of year 2 settlements are executed. Finally, the market opens for trading period 3 which is day 1 year 3. At this time only two fixed income markets are remaining (the coupon bond and the original 3-year zero coupon bond). At the end of this period, time again flashes by and end of year 3 settlements are executed and your entire position is now converted to cash.

The coupon bond pays a coupon rate equal to 10% relative to 100 face value and three zero -coupon bonds have a face value equal to 100. The cash flow(s) from each bond at the end of each year is summarized in the table provided in the section labeled Case Data.

You can make market (as a dealing desk) and/or take market (as a regular investor) in this trading exercise. As a market maker you can submit a Bid to buy some number of units up to 10,000 units or an Ask to sell some number of units up to 10,000 units. At any point in time the best bid and ask will be displayed on the trading screen. Additional bids and asks will be visible in the central market book. As a market taker you can submit market orders to buy from the ask, any quantity up to what is available. Alternatively, you can sell to the bid, up to the quantity available. In addition, you can transmit a market limit buy or market limit sell order by specifying both a price and a quantity. This order type buys from the ask, up to the price you indicate or sells to the bid, down to the price you indicate. As a result, it provides additional protection compared to an unprotected market order.

The interest rate applicable to cash balances in your money market account is 4% APR (Annual Percentage Rate) for year 1. That is, if you have $x at the end of day 1 year 1, interest will accrue such that your end of year 1 cash balance, before any bond settlements, is $x*1.04. After interest is accrued then coupon payments are paid, and the 1- year zero coupon bond is settled. In year 2, the rate of interest in the money market is 10% APR, and in year 3, it is 16% APR. No interest is accrued or paid within the trading day (i.e., you have a free float for all trading activities). At the end of any trading day your cash balance can be positive or negative (i.e., you have borrowed cash for one year). The same money market rate applies to positive or negative cash balances. That is, the borrowing and lending rates are the same.

Financial markets let you sell securities that you do not own. This is referred to as short selling. Two situations can arise: I. You can sell bonds short during the trading period and keep a short position by the end of the trading day. II. You can sell bonds short during the trading day but cover your short sales before the end of the trading day. The consequences from each type of transaction are described next.

I. If you maintain a short position at the end of the day’s trading session you are legally obligated to pay any coupons and/or face value on that bond at the end of the year. The proceeds from your short sales, however, are automatically deposited in your money market account and will earn interest over this time.

II. Suppose you short bonds during the trading period but cover your position (i.e., buy back the bonds you shorted) before the period ends, you will receive the net difference between the price you shorted at and the price you bought back. There are no interest implications because no interest is accrued or paid during the trading day.

	Payout at end of Year 1	Payout at end of Year 2	Payout at end of Year 3
Coupon Bond	10	10	110
1-Year Zero	100
2-Year Zero		100
3-Year Zero			100
Money Market	4% APR	10% APR	16% APR

At the end of each trial you earn a trading bonus that is cumulated across trials. Your trading bonus in any trial equals 0.0001 times your closing balance of market cash. That is, if you end up with negative wealth then you earn negative grade cash and if you make money then you gain grade cash. Your trading rank in the market is also computed on the basis of your trading bonus.

Trading is conducted over a number of independent trials and a record of your cumulative grade cash is maintained.