Trading Case B05

 

 

Case Objective

To understand valuing short maturity zero coupon bonds (Russian GKO’s) from an interest rate tree.

 

Key Concepts

Term structure of interest rates; interest rate risk; unbiased expectations; risk premium

 

Case description

The objective of this case is to introduce you to the problem of valuing fixed income securities from trinomial interest rate trees.  This type of environment is often used in practice to value derivative securities.  The trading setting for B05 is loosely based upon an emerging fixed income market in Russia.  The short term rouble-denominated zero-coupon bonds known as GKO’s are the most liquid fixed income markets in Russia today.  They are traded by authorized dealers on the Moscow International Currency Exchange.  Government demands have resulted in an increasing supply of these securities but restrictions on foreign investors to 10% have limited demand.  Interest rates are relatively large and volatile and often depend upon expectations regarding Government budget requirements as well as potential Central bank intervention.  Ultimately this market failed

Historical Note

Between March 1995 and October 1995 annualized GKO rates reported by the Moscow Interbank Currency Exchange reveals a downward shift in interest rates of  approximately 12,500 basis points.   Subsequently this blew out again and in August 1998 the Prime Minister Kirienko (just prior to his demise) declared a 90-day foreign debt moratorium and announced a de-facto default on the government's domestic bond obligations.

 

There are 3 zero-coupon bonds maturing 1-month, 2-month and 3-months from the present time. Future 1-month spot interest rates are large and quite volatile. Possible spot rate movements can be accurately represented by the following interest rate tree:  

 

That is, the initial spot rate is 6.5% for 1-month (i.e., not annualized).  At the beginning of month-2 the realized 1-month spot rate can change to 5%, 9% or 11% etc., (equally likely).   You can trade any security but you can only trade during the first day of each month.  At the end of each trading day time flashes by and interest accrued (or to be paid) from your cash end of day 1 cash balances is settled.  Shortly after the market opens for day 1 of month 2.  Again at the end of trading time flashes by, adjustments are made and finally the market opens for day 1 of month 3.

 

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.  Finally, borrowing and short sales are permitted. 

 

Case Data

The cash flows from the securities are:

 

 

Earning Grade Cash  

Your aim is to make as much money as you can which depends upon how well you trade relative to the prices discovered by the market.   Each trial you earn grade cash that is cumulated across trials.  Grade case in any trial equals 0.0001 x your closing balance of market cash.  That is, if you end up with negative wealth then you lose grade cash and if you make money then you gain grade cash.

 

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