Fixed Income
Trading Game and Tutorial
For SEBC
May 8, 2004
Sanjiv Parekh
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:
• Email Us:
Fixed Income Trading Game and Tutorial
http://mitsloan.mit.edu/trader
taskforce@mit.edu
Agenda
• Today’s Game:
– Zero coupon bonds and 10% coupon bond
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Bond Valuation
Trading Mechanics: Bid-Ask
Trading Interface
Two Practice Games
Questions and Answers
The Final Game
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
Fixed Income Trading Game and Tutorial
Coupon Bonds
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PV = Present Value = price of bond today
Ct = Coupon at end of year t
FV = Face Value = $100
rt = Interest rate for year t
C3  FV
C1
C2
PV 


1  r1 (1  r1 )(1  r2 ) (1  r1 )(1  r2 )(1  r3 )
Fixed Income Trading Game and Tutorial
10
10
110
1
2
Year
3
Zero Coupon Bonds
FV
1-year maturity: PV 
(1  r1 )
FV
2-year maturity: PV 
(1  r1 )(1  r2 )
FV
3-year maturity: PV 
(1  r1 )(1  r2 )(1  r3 )
Fixed Income Trading Game and Tutorial
100
1
2
Year
3
100
1
2
Year
3
100
1
2
Year
3
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
Fixed Income Trading Game and Tutorial
Building Replicating Portfolio
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w1 = Weight of 1-year zero
w2 = Weight of 2-year zero
w3 = Weight of 3-year zero
C1 = w1 * 100
C2 = w2 * 100
C3 = w3 * 100
PCoupon = w1P1-year + w2P2-year + w3P3-year
Fixed Income Trading Game and Tutorial
Arbitrage Opportunity
• Price of replicating portfolio: PR
• Price of coupon bond: PC
• If PR < PC
– Sell coupon bond, Buy the appropriate zeros
• If PR > PC
– Buy coupon bond, Sell the appropriate zeros
• Buy low and Sell high
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
Fixed Income Trading Game and Tutorial
The Bid-Ask Spread
BID
ASK
158 1/8
158 7/8
Market maker buys
Market taker sells
Market maker sells
Market taker buys
Fixed Income Trading Game and Tutorial
Stay Within the Spread
Bid
buy
160
sell
159
$$$
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•
Ask
sell
159
buy
160
$$$
Do not trade outside the spread
Be the market maker with unsophisticated traders in the market
Fixed Income Trading Game and Tutorial
Being the Market Maker
Ask
90
89*
Bid
80
81*
MARKET
New Bid Makes the Market
New Ask Makes the Market
(Market Maker)
(Market Maker)
• Bid-Ask spread goes from 10 to 8 once
the new bid and the new ask make the market
Fixed Income Trading Game and Tutorial
Being the Market Maker
Ask
90
Bid
80
91
79
MARKET
Bid does NOT Make the
Market
Fixed Income Trading Game and Tutorial
Ask does NOT Make the
Market
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.
Fixed Income Trading Game and Tutorial
Trading Interface
You can borrow
or lend at a variable
interest rate
Security Names
Seconds remaining for
current trading period.
Traders in the FTS
markets determine prices
Fixed Income Trading Game and Tutorial
Realized payouts
displayed here
Individual
endowments
Logging In
Enter any trading name
(at least 3 characters)
Type in the actual names
of each trader on the team
DO NOT PRESS CONNECT UNTIL ASKED TO DO SO
Fixed Income Trading Game and Tutorial