Trading Case ST2
Important Note: This is an advanced module case. To run this case the FTS Trader must be
downloaded from the Trader Help section of the Virtual Classroom page (from the
hyperlink Trading Case ST2). Similarly,
the FTS Market must be launched from the hyperlink under Instructor Help on the
Virtual Classroom page. To see this
requires logging in as a moderator). The
case will not run properly under the regular FTS Markets.
Case Objectives
To understand how a market maker hedges the price
risk from inventory changes by applying delta hedging and other option trading
strategies. Making
market in options in a “Black Scholes” world. To gain experience with real world option
support systems.
Key Concepts
Delta and gamma hedging in a
world where prices evolve in continuous time but trading takes place at
discrete points in time (every week). Trading
takes place in an idealized constant
volatility world. The environment is
the same as trading case ST1 except that market making in some options is
permitted.
Case
description
ST2 is a trading case
designed to introduce you to the problem of hedging
the position profits associated with an active market maker's inventory of
stock. This inventory of stock will
change over time as a result of active market making in the stock.
Your objective is to
hedge the profits generated from market making activities in the underlying
stock at positive bid/ask spreads.
However, the spread profit is exposed to price risk because the number
of buyers and sellers at a point in time is random and therefore the trading
book is rarely balanced. This imbalance
means that although you are earning a return from a posted spread, you cannot
avoid taking some residual changing position in the stock. The changing residual is the source of price
risk that you are exposed to in this trading exercise.
To manage the price risk
you can trade in the option markets. In one put/call
market you can only take market but
in the other put/call market you can make
market and take market.
As an aid to this
exercise you are provided with a set of real-time analytical support
tools. Using these tools you can monitor
the delta of your position at each
point in time.
Market environment
The Stock Market
The stock market trades the stock of a large computer manufacturer called IMB. Although this stock has suffered from major price corrections over recent history analysts expect that these corrections are finished. The following statistical process describes expected future price behavior:
|
Volatility of return (): |
30% per annum |
|
Spot Price: |
346.826 |
|
Expected Drift (): |
5% per annum +/- error |
|
Unit of Time: |
1 month (45 seconds
FTS time)—default parameters) |
This process is expected
to remain stationary over the next year.
In addition, due to the recent weakness in the stock price, analysts
expect no dividend payments over the next year.
Your inventory of stock
is marked to the market price of IMB at the end of the trading period
(approximately one year of calendar time).
The Treasury Strip Market
The Treasury strip market
is a risk-free zero-coupon bond that pays $900 at the end of one year,
regardless of which path the stock market takes. The riskfree rate
is 3.25% per annum (continuously compounded).
The European Options Markets
The
The time to maturity for
each option is one year and the terminal payoff for each option depends on the
realized value for IMB at the time of their expiration. For example, for the options with a strike
price equal to 320, the following terminal values apply:
Terminal value:
At the end of their life
options are automatically exercised if they are "in the money."
Trader Endowments
As a trader your task is
to manage the exposure of your position to price risk. Your underlying stock position can change
every week, reflecting the market making activities of your firm in the IMB stock. This stock position cannot be traded. However, you can manage your exposure by
trading in the options market.
Trading Restrictions
Trading is restricted to
the options and the strip markets only.
Option trading is
permitted in all option markets. In the strike 320 options you are a market
taker only, and in the strike 360 options you can both make market and take
market.
An option contract is for
one stock. You can trade upto 10000 contracts in a single trade (i.e., click of the
mouse). You can build a position through
multiple trades (i.e., repeated clicks of the mouse).
Shortselling
in the treasury strip market is permitted. This allows you to borrow (lend) at
the risk-free rate by shortselling (buying) treasury
strips. Holding market cash pays zero
interest and borrowing is not permitted in the cash market. If you want to buy options but have
insufficient cash you must first shortsell the
required amount of treasury strips and then purchase the desired amount of
options.
The spot risk-free rate
of interest for a Treasury strip with one year to maturity is currently 3.25%
per annum .
This rate is not expected to change over the next year.
Options Support System
You should launch the
Excel spreadsheet ST2 for your trading support system. See instructions for ST1. Your ST2 support spreadsheet is the same as
the ST1 support spreadsheet with the addition of option pricing support. This option pricing support can be used as a
guide to your market making strategies.
Trading Objective
Your trading objective is
to earn as much grade cash as
possible.
Earning Grade Cash
Securities are exchanged
using market cash in a trading period lasting year and which is referred to as
one trading trial.
Multiple independent
trials will be conducted. This means
that for each trial you will restart with an initial endowment that is either
Type A or Type B, and an independent path for the stock prices is generated
(starting from a spot price around 347).
If at the end of any
trial you have a closing balance of $45,000 market cash you will earn $6 of
grade cash. If you have a closing
balance of market cash that is lower than $45,000 you will earn $0 grade
cash. Any amount of market cash that is
greater than $45,000 and less than or equal to $200,000 earns grade cash as
follows:
Above $400,000 market
cash earns the maximum $23.75 grade cash for one trial.
Trading is conducted over a number of independent
trials and a record of your cumulative grade cash is maintained.