Note: don't assume information for trading sessions will be the same as that given in the case descriptions. The information (interest rates, etc.) will be displayed by the system at the beginning of the session.
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 and gamma of your position at each point in time.
In ST2, you can access additional support windows by first clicking on the menu item Support in your Trading Screen. Once you have initialized this support system you will automatically see the market value, delta and gamma of your position in real time. By clicking on any Option label in this Option Support Window will popup and update an option calculator support window.
Each time you want to update the calculator be sure to click on the option label in the Option Support window first.
FTS markets are open for approximately three months of calendar time at the end of which your position is marked at the realized prices. FTS time is condensed so that one week is equal to 30 seconds.
THE STOCK MARKET
Trading in this stock is permitted at the displayed prices that are updated weekly.
Your inventory of stock is marked to the market price of IMB at the end of the trading period (approximately three months of calendar time).
The time to maturity for each option is three months 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:
Call Option = Max[Marked value – $320, 0]
Put Option = Max [$320 - Marked value, 0]
At the end of their life, options are automatically exercised if they are "in the money."
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 up to 99 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). Prices are quoted in whole dollars.
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 3 months to maturity is currently 3.25% per annum. This rate is not expected to change over the next 3 months.
If you combine this information with the annualized risk-free rate and volatility information (provided in this case) then you can apply the options calculator to compute the Black-Scholes option price.
The Black-Scholes option price can be used as a guide to your market making strategies.
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:
Grade Cash = $6 + [(Ending Balance of market cash - $45,000)/ 155,000] x $4
Above $200,000, market cash earns the maximum $10 grade cash for one trial.
Trading is conducted over a number of independent trials and a record of your cumulative grade cash is maintained.
If you do not have a copy of this program, you may download a program that works for Windows 95 or NT now [this is a self-extracting ZIP file that you must install on your computer to read PDF files]. If you want the current version of the Adobe Acrobat Reader for other platforms, visit Adobe's web page.
Click here to download this assignment.
A histogram showing the grades for this quiz is available in Acrobat's portable data format (.pdf). The file is about 34K and can only be viewed (and printed) using a copy of Acrobat Reader.
Click here to download this graph.
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