Trading Case
SW0
Case Objective
In this case approximately one third of the trading
crowd are trading desks for large financial institutions and two thirds of the
trading crowd are firms. Each firm’s
objective is to manage interest rate risk by trading swaps as market takers and
each desk’s objective is to make money by making market in swaps. In addition, financial institutions can deal
among themselves in two offshore deposit markets. As a trader in SW0 you will be randomly
assigned to being either a firm or a financial institution and this role may
change across market trials. Financial
institutions will open each trading trial with a flat position – zero
endowments of cash and securities. As a
result, a trading desk’s end of trial cash represents their dealing gains or
losses from trading in the market. Each
firm will open with a position that has a zero net present value given prior
information. Part of this position,
(i.e., coupon bonds) is non tradable.
This locks each firm into an interest rate risk exposure which they can
only manage by trading interest rate swaps.
Different firms will have opposing starting positions so that managing
interest rate risk will generate both buy and sell orders from the market
taking firms in the swap markets.
Offsetting demands in the swap markets from market taking firms can be
filled from the dealing activities of financial institutions competing against
other financial institutions. All firms
will start with a position that has a zero present value with respect to prior
information (i.e., information available before the trading trial starts).
Key Concepts
Eurodollar deposits, interest rate swaps, managing a
swap book from both the client and dealers perspectives.
Cash (or Money)
Market: Firms will either have a long or short
initial position in the cash or money market.
As a result, in this market you are either receiving or paying the
realized 1-period spot rate of interest each period.
Coupon Bond: Firms will have an initial long or short
position in a three period coupon bond.
Coupon rates are paid relative to LIBOR (the realized spot London
Interbank Offer Rate). This market
cannot be traded and so an Institution’s opening balance represents the
institutions exposure to fixed interest rate risk. The face value of this bond is USD$1,000,000
and the coupon rate is 2% per annum. Coupon frequency, is semi-annual in
this case.
2-Period
Eurodollar deposit: This is a deposit market open
to among dealer trading. The initial
deposit per unit is USD$1,000,000 and the rate for the deposit is the price you
negotiate in the market. That is, rates
are bid or asked for. The rate
determines the terminal value of your deposit at the time of maturity payable
a semi annual basis. Quotations for
rates are annualized and in percentages consistent
with the real world markets. For
example, if you hit a quote of 1.5 this is applied is applied as 1.5% per annum, assuming simple or add-on interest rate form to the initial
deposit.. In this market you have both
dealing (i.e., market making rights) as well as regular market taking
rights. In the example titled market
making vrs market taking below we will illustrate precisely what the
differences are.
3-Period
Eurodollar deposit: This is the same as the
previous market except the life is three periods.
3-Period Interest Rate Swap Trading Desk A: This is a swap market quoted in terms of the rate applicable to the fixed leg. That is, long a swap pays fixed and receives floating relative to the notional principal of $1,000,000. Trading desk A contains quotes from the set of swap dealers from in the market. The quotation convention for the swap is an annualized fixed rate quoted as a decimal annualized. It is applied to the fixed leg for 6-month (0.5 of a year) reset periods.
Market Trials
A market trial
covers three periods of calendar time (i.e., 18-months). Trading takes place in only the first two
periods. In period 3 markets will open
and immediately close so that all positions are marked to market in period 3 at
the realized LIBOR rate but no further trades are permitted.
Period Length: Each period covers 0.5 of a year.
The spot interest rate for the first 182 days is 1.29% per annum. The future rates covering the next two periods are stochastic when viewed from the beginning of a trading trial. The possible set of realized spot rates at the beginning of periods 2 and 3 contain three possibilities each period. The three possibilities are high, medium and low. For period 2, the high rate is 1.5% per annum, medium is 1.25% per annum, and low is 1% per annum. Each rate is equally likely. For period 3 the possibilities are 1.99% per annum, 1.39% per annum, 1% per annum again each is equally likely.
You can short sell any security and borrow and lend
at the current realized spot LIBOR rate for the period.
Prices in this case are determined by the traders,
so all trades will take place at bids and asks that either you or another
trader in the system puts in.
Case Data
The cash flows from the bonds are:
|
|
Payout at end
of Period 1 |
Payout at end
of Period 2 |
Payout at end
of Period 3 |
|
Cp Bond |
$1M*0.02*0.5 |
$1M*0.02*0.5 |
$1M*0.02*0.5 |
|
Deposit 2-Per |
0 |
If purchased in period 1:
$1M*(1+price) If purchased in period
2: $1M*(1+price*0.5) |
|
|
Deposit3-Per |
0 |
0 |
If purchased in period 1:
$1M*(1+price*1.5) If purchased in period
2: $1M*(1+price) If purchased in period
3: $1M*(1+price*0.5) |
|
SwapDESKA |
Reset Period 1: Long swap pays $1M*price*0.5 and receives $1M* realized decimal spot rate * 0.5 Notional is not exchanged |
Reset Period 2: Long swap pays $1M*price*0.5 and receives $1M* realized decimal spot rate * 0.5 |
Reset Period 3: Long swap pays $1M*price*0.5 and receives $1M* realized decimal spot rate * 0.5 Notional is not
re-exchanged |
|
SwapDESKB |
Same as DESKA |
Same as DESKA |
Same as DESKA |
|
SwapDESKC |
Same as DESKA |
Same as DESKA |
Same as DESKA |
Price
in the above is the quoted decimal “annualized rate.” That is, price is day count adjusted in
accordance with the money market convention.
Money Market Time Line
In
the money market your cash balance will either accrue or pay interest at the
spot rate for the current period times your closing balance. That is, within trading day transactions do
not attract interest. You can borrow or
lend from your cash account during trading.
Examples
Trading
in the money market is different to trading in regular bond and stock
markets. As a result, we will work
through some examples that illustrate what happens when you either make market
or take market in the Eurodollar deposit markets or the swap markets. In particular, you should become acquainted
with what it means to have a “long” or “short” position in these markets and
how the cash flows work relative to how they are quoted.
Example 1
(Market Making versus Market Taking Eurodeposit Market): By dealing and trading in this market the trading
crowd determines a bid/ask spread.
What is a bid and ask?
In the deposit market a “bid” is the dealer’s posted
“borrowing rate.” That is, if you submit
a bid to this market at i% for 1 unit, you are prepared to borrow $1,000,000
for the remaining life of the deposit at i% (applied on an Actual/360 day count
basis. If some other trader hits your
bid then your cash balance will increase by $1,000,000 and at the end of the
deposit’s life you will repay $1,000,000*(i/100)*(Actual days/360) from the time you purchase the $1,000,000
until the time of maturity.
Similarly, the ask is the dealer’s “lending rate.” If you submit an Ask at j% for 1 unit then
you are prepared to lend $1,000,000 for the remaining life of the deposit at j%
applied on an Actual/360 day count basis.
A positive bid ask spread in the Eurodollar deposit
market implies that the market maker is prepared to borrow at a lower rate than
the market maker is prepared to lend. For
example, suppose the following set of transactions are realized.
Transaction 1:
Market maker posts a bid of 1.5% for 100 units. That is, the market maker is prepared to pay
1.5% for up to $100 Million of deposits
If the dealer’s bid is hit for 1 unit (i.e., $1M)
the dealer receives $1,000,000 from the client and the client’s cash account is
decreased by $1,000,000. At the end of
the deposits life the dealer repays the client $1,000,000*1.015*0.5.
If any trader double clicks the security name on the
trading screen they will see the trading book plus how it adjusts in real
time. On this screen you will also see
your future obligation associated with your current position in this Eurodollar
market. For example, the active market
maker whose bid was successful will see the obligation (i.e., a negative
number) of $1,000,000*1.015*0.5).
The client who hit the bid will see +$1,000,000*1.015*0.5.
The “Ask side of a deposit market”
This is a “loan market” and the dealer is prepared
to lend to the client at the Ask %.
Continuing this example suppose the dealer has posted the bid/ask spread
at 1.5% for 10 units bid, and 2.0% for 10 units ask. In this case the dealer is prepared to lend
cash to the client at the rate of 2% per annum.
As a result, if the client hit’s the dealer’s Ask then the client
receives +$1,000,000 and is obligated to payback a terminal amount equal to
$1,000,000*1.02*0.5. So cash at
the time of the transaction increases and the obligation is negative and equal
to $1,000,000*1.02*0.5.
Example 2
(Market Making versus Market Taking Swap Market)
If a dealer posts a bid/ask spread of 1.5 for 10
units and 2.0 for 10 units to the swap market it works as follows.
First, a bid of 1.5 for 10 units implies that the
market maker is prepared to buy up to 10 swaps (up to a total notional
principal of $10,000,000) for a fixed rate of 1.5% fixed each reset in exchange
for the floating rate each reset period.
No cash is exchanged at the time of entering into 10 swaps, but at the
end of reset period the buyer (i.e., long side) is obligated to pay fixed
applied as $10,000,000*(1.5/100)*(0.5) in exchange for receiving $10,000,000*(Realized
spot rate % for the current reset period/100)*(0.5). At the end of the life of the swap no
notional is exchanged only the final net interest rate payment.
Market Takers Perspective: Suppose you hit the market makers bid for the
10 swaps at 1.5%. The market maker is
long 10 swaps and you will be short 10 swaps.
Being short implies that you are obligated to pay Libor flat in exchange
for 1.5% applied to the notional principal at their respective day count
conventions. That is, at the end of each
reset period you receive from the market maker $1,000,000*0.015*0.5 and in
exchange you pay the market maker the realized 1-period Libor applied as
$1,000,000*realized Libor as a decimal*0.5.
Summary of Cash
flow implications: No cash is exchanged at the
time of entering into the swap. At the
end of each reset period the long side pays the fixed rate obligation day count
adjusted and receives the floating rate in exchange day count adjusted. In both cases the rates are applied to the
notional principal. Finally, at the
swaps maturity no notional is exchanged but the final interest rate transfer is
realized.
Earning Grade Cash
Your goal is to manage both your risk and return of
your position. All traders will commence
with a position that has a net present value equal to zero at the beginning of
trial 1. That is, all traders commence
with an ex ante position that has an equal net present value relative to the
set of possible interest rate paths across the three periods. Your goal is to implement the objective
associated with your assigned role. Your
terminal market value is computed from your final cash balance after your
position is marked to market at the end of period 3.
Performance
Evaluation: After the trading session you will be
evaluated as follows. Each trial your
rank in terms of the current trial’s market cash is computed and across trials
your average ranking on a per trial basis is computed relative to your assigned
role (dealer or firm).