Trading Case B06

 

Case Objective

This the the same trading case as B05 except now traders can get private information about future spot rates.   As a result, the objective is to apply efficient market concepts to fixed income markets.

 

Key Concepts

Term structure of interest rates; informational efficiency/rational expectations; information and the shape of the term structure of interest rates; unbiased expectations, liquidity premium

 

Case description (see B05)

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.  Each zero-coupon bond pays $100 at the the time of its maturity.  Possible spot rates are 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.

 

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. 

 

Private Information

Each month the spot rate of interest can undergo a high (x), middle (y) and low change (z).  You may receive private information at the beginning of a month in a form (e.g., “Not y”) that lets you eliminate a spot rate from being feasible.  The private information is randomly assigned such that the market as a whole knows more than any trader’s private information reveals.

 

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.