A Pit-Trading Approach to Teaching FOMC Announcement Analysis

Transcription

1 A Pit-Trading Approach to Teaching FOMC Announcement Analysis Jeffrey Brown, University of Idaho Jonathan Clements, University of Idaho Terrance Grieb, University of Idaho Christian West, University of Idaho ABSTRACT This paper details a market created by faculty and students at the University of Idaho to trade contracts on the future actions of the Federal Open Market Committee The contract structure is similar to those used on the Iowa Electronic Market for election markets, and features a pit trading format This market, known as the University of Idaho Barker Exchange (UIBX) was created as part of the Barker Capital Management and Trading Program at the University of Idaho OVERVIEW AND STATEMENT OF LEARNING GOALS The University of Idaho Barker Exchange (UIBX) is a unique opportunity for students to participate and experience pit-trading of Federal Open Market Committee futures This market was created primarily as a teaching tool to aid in classroom lectures Students often participate in discussions of rate policy after a decision has been announced It was our goal to have students research and proactively develop an outlook for the upcoming rate decisions and then discuss opinions before the FOMC meetings Students are able to fund trading accounts with their own money This creates a market with financial risk and, hopefully provides students with the motivation to take an active interest in the FOMC rate setting process Three primary learning outcomes are tied to this exercise The first is that students will have a better understanding of FOMC decision outlook probabilities, the second is a better understanding of the structure and usefulness of Iowa Electronic Market (IEM) style contracts The final learning goal is to give students a first hand experience with a pit trading environment LITERATURE REVIEW Engaging students in classroom activities has long been advocated as a means of increasing student interest in class material, and increasing the quality of learning Simkins (1999) notes that new instructional technology tends to increase students enjoyment of their class exercises, and therefore increases the opportunities for student involvement However, he goes on to argue that the real challenge is using this technology effectively to develop an activestudent-learning environment He argues that the use of technology can only be effective if it is structured so that it enables and encourages students to practice economic concepts while

2 actively engaged in the learning process He cites trading on the IEM s political stock markets as one way to accomplish this The IEM is a totally web-based experience In contrast, Holt (1996) and Bergstrom and Kwok (2005) explore the benefits of using a pit trading environment to encourage active learning for economics students Holt (1996) notes that this format reduces the level of abstraction in economic concepts and makes complex material more accessible to students at every level He combines preparatory lectures and class discussion to set up a supply-and-demand driven price discovery game using a deck of playing cards Bergstrom and Kwok (2005) design a similar supply-and-demand game to price apples as a commodity to test prediction of competitiveequilibrium theory versus a simple profit-splitting theory They found that multiple pit trading sessions tended to produce outcomes that were more in line with results predicted by competitive equilibrium Relative to equilibrium process for the IEM, Gomme (2003) reports a prediction error of only 137 percentage points Likewise, Stix (2008) reports that the predictive power of the IEM structure has been consistently more accurate than standard political polls from 1988 through 2004, and that this applies to election day as well as five days and 100 days prior to the election However, he also notes that a theoretical model describing why political markets are stronger predictors than polls has yet to be definitively identified In their seminal examination of political stock markets, Forsythe, Nelson, Neuman, and Wright (2001) provided evidence supporting both the Hayek hypothesis and the marginal trader hypothesis They argued that the early results for the IEM (know then as the Iowa Presidential Stock Market) demonstrated that markets provide an efficient price discovery process even if the participants have limited information sets (the Hayek hypothesis) and that this is possible because of the existence of marginal traders who are free of judgment bias (ie, they behave as the proverbial economic person ) who make abnormal profits by consistently buying and selling at the equilibrium price (the marginal trader hypothesis) Similar evidence is provided by Oliven and Rietz (2004) who find that market makers on the IEM make fewer judgmental bias errors and make greater profits than price takers However, a number of studies have contradicted these results For example, Bruggelambert (2004) provided evidence that excess profits were achieved by traders who took advantage of other people s mistakes rather than the existence of asymmetric information In addition, they provided evidence that prices themselves were a significant source of information on which expectations were based Likewise, Bondarenko and Bossaerts (2000) show that IEM participants across the board correctly update their price estimates based on price and other information in a way that is consistent with the rules of conditional probability (Bayes law) This paper is not focused on testing those hypotheses, but rather, we are more concerned with designing an effective learning experience for students However, the existing literature has several implications that are important for the creation of our market First, we note that a combination of technology and direct participant interaction is most likely to be an effective format This provides the dual benefits of increasing students enjoyment in learning the material while also making complex material less abstract and more intuitively accessible Second, we note that informing students about the market structure and basic trading strategies beforehand is paramount in reducing judgmental bias errors and increasing the competitive equilibrium component in the price discovery process This translated into a significant amount of time being spent with the students before hand describing concepts such as bundles vs contracts, limit and market orders, bid-ask spread, identifying arbitrage opportunities, and so forth

3 DESCRIPTION OF THE UIBX In 2007 the University of Idaho was the recipient of an Alumni donation to start the Barker Capital Management Trading Program, giving students hands on experience in financial markets As part of the donation, the Barker Capital Management Group was founded In addition to managing some of the endowment's assets, the group has undertaken several extra research projects in various financial market topics One of these projects was to analyze financial contracts as a predictive probability tool Research led the group to the Iowa Electronic Market (IEM) We discovered that the IEM FOMC rate policy futures (now discontinued) could not be easily used to analyze market predictions of the FOMC Since the contracts generally trade based on a rate increase, decrease, or no action, it is often difficult to form meaningful predictive probabilities This is especially true when there is near certainty that the FOMC will raise or cut rates, but there is much uncertainty surrounding the size of the rate change As a result, the IEM s current Federal Reserve Market Policy market is closed and inactive The Chicago Board of Trade (CBOT) trades Fed Funds rate futures and options that can be used to find predictive outcome probabilities for the FOMC rate decisions However, the CBOT contracts only provide binomial probabilities (unless options on the futures are modeled) and therefore did not fit easily into class lectures We liked the simplicity of the IEM style market and wanted to develop a similar contract that would allow students the opportunity to learn about FOMC Fed Funds rate markets while at the same time giving predictive outcome probabilities that could be analyzed Thus the University of Idaho Barker Exchange was created A separate goal that developed as a part of this project was introduce open outcry pittrading to students, and to show how electronic posting of bid-ask spreads and market depth support this format Over the last two decades exchanges have been listing more securities on electronic platforms Volume has shifted from the old open outcry pits to the new electronic trading systems As the pits grow smaller and smaller many have started to forget that they are still a vital part of many large contracts that trade in the United States Combining the IEM style contract with a pit-trading environment allowed us to address all of these objectives The market is composed of three independent operations: student traders, runners, and the clearinghouse Students are introduced to the basics of pit trading from the professor to learn how to interact with each other as buyers and sellers, maintain their personal balance sheet and respond to price changes around them Students operate under an individually chosen three letter trading symbol which they wear as a badge DESCRIPTION OF CONTRACTS AND TRADING The University of Idaho Barker Exchange (UIBX) combined both the IEM and CBOT style FOMC markets into a blended hybrid FOMC market The contract specifications were laid out for students in a specs document, which is attached as Exhibit A ~ EXHIBIT A~ Participants bought bundles for one-dollar, and each bundle consisted of four contracts The contracts are designated by "A", "B", "C", and "D" tickers Based on current market conditions, each contract represents a specific FOMC rate announcement For example, for the March 18, 2008 FOMC meeting, the A contract represented no change in the target Federal Funds rate, the B contract represented a 25 basis point rate cut, the C contract represented a 50 basis point rate cut, and the D contract represented the rest-of-the-market (meaning

4 anything not covered by the A, B, and C contracts) This made sense because there was no substantive probability of a rate increase given the current market conditions for that FOMC meeting The market closes when the FOMC announcement is made One single contract represents an action taken by the FOMC and pays $1 for the corresponding action being taken by the FOMC, all other contracts are worthless and pay $0 Once a bundle is purchased, the individual contracts can then be sold on the UIBX market to other traders Students were allowed to fund trading accounts with the UIBX for a minimum of $2 and a maximum of $20 A separate clearing house, managed by three students, ensured bundles, contracts, and cash balanced after every trade Exhibit B shows examples of a ticket used to buy bundles and also an example of the matching trade order tickets for a buy/sell transaction for five of the D contracts ~EXHIBIT B~ The contract s bid/ask spread was determined by limit orders, and that was displayed along with the last executed trade for all participants to see All trades occurred in an openoutcry pit trading session that was held once a week up until the FOMC meeting for that futures contract A sample of the quote board showing the outstanding bid-ask limit orders for the four contracts is show in Exhibit C ~EXHIBIT C~ The classroom features a large projection screen which the clearinghouse uses to clearly display the quote board Students interact with each other, searching for buyers and sellers of contracts and negotiating prices desired Once an agreement is made, students complete a purchasing contract including the number of shares bought or sold, the price agreed upon and the participant s trading symbols The buyer and seller then verbally call for a runner The runners respond to the verbal signal and carry the completed purchasing contract to the clearinghouse at the front of the room The runners allow trading students to continue searching for new buyers and sellers without the delay of manually bringing sale contracts to the clearinghouse The runners give the sale contracts to the clearinghouse and then return to the trading floor repeating the process The clearinghouse is staffed by three students who record every contract sale, the changes in each student s account, and pass on the information to the recorder who posts last sale price and number of contracts onto the display board Student traders constantly refer to the postings on the display board and act accordingly to the contract s changes in price The clearinghouse is also responsible for keeping track of the positions held by each of the traders A master spreadsheet as shown in Exhibit D was used to clear the trades into the individual accounts This also became a useful tool for after-the-fact discussions with students about back-office operations for a brokerage firm ~EXHIBIT D~ BID/ASK SPREADS The concept of the Bid-Ask spread is very important to the structure of financial markets and it can also be a confusing concept for students not actively involved in trading Dealers post their Bid price as an offer to buy and their Ask price as an offer to sell However, an investor looking at the quote board must understand that the Bid represents the price buyers are willing to pay, while the Ask represents the price sellers want to receive These two prices will differ by some amount which is referred to as the Bid-Ask spread For example, contract A has a Bid or 010 and an Ask of 015 Thus, buyers are willing to buy at 010 and sellers are willing to sell at 015 This 5 cent spread creates two scenarios First,

5 buyers and sellers can adjust their price and meet in the middle of the spread Alternatively, buyers have to buy at the Ask price and sellers have to sell at the Bid Price In electronic markets, the latter case seldom occurs and participants must either hit the Bid or lift the Offer However, participants in an open outcry market, who have common knowledge of the current bid-ask quote, can mutually agree on a price closer to the Bid-Ask midpoint If a trader enters a limit order to buy they have created a Bid If their limit order is outside the existing Bid-Ask spread they may not get filled unless price action moves in their direction Alternatively, if the trader enters a buy order at the Ask price, they have created a Bid and simultaneously bought at the Ask price Conversely, when a trader enters a sell order they create an Ask If this Ask is far away from other Bids, it may not get filled However, if a trader enters a sell order at the current Bid price, they have created an Ask and sold at the Bid While this information is well covered in textbooks, and common knowledge to traders, it is more difficult to convey this information to students In our case we use a current quote board such as the one shown in Exhibit C This allows students to see first hand how the Bid-Ask spread is created, and also how they can execute orders by either 1) taking the market price (ie, hit the Bid or lift the Offer), 2) place a limit order outside the Bid-Ask spread and wait for price action to (potentially) fill their order, or 3) negotiate a trade with another pit trader ARBITRAGE Given that the contracts are mutually exclusive and are all contained in the purchase of a one-dollar bundle, arbitrate opportunities can exist in the market When four contracts are used the contracts Bid prices must sum to at most one dollar The amount that the Bid prices total is over one dollar represents an arbitrage opportunity in the market A trader can purchase a complete bundle for $1 and then sell off the individual contracts (A, B, C, D) in the open market at the current Bid and arbitrage the contracts to keep the profit By this process arbitragers are able to enforce the law of one price in the market For example, if the Bid prices are as follows; A 10, B 30, C 40, D 30, then an arbitrage opportunity has been created A trader that sees the above prices can sell one of each of the four contracts for a total of $110 ( ) and purchase the contracts for $100 The trader has just arbitraged $010 out of the market If the market has a small number of participants this opportunity can easily happen As the number of traders increases, the arbitrage opportunity decreases The concept of arbitrage also applies to the Ask prices in the open market By the same logic as above, the sum of the Ask prices for the four contracts must be at least one dollar If the Ask prices to sum to less than one dollar in the open market, then an arbitrager can purchase the individual contracts for less than one dollar and sell the bundle (all four contracts) back to the market maker for one dollar For example, suppose the Ask prices are as follows: A 05, B 25, C 35, D 25 In this case the ask price of the four individual contracts sums to $090 The arbitrager can buy one of each of the contracts and then sell then as a bundle for $100 for a $010 profit OTHER MAKET STRATEGIES Given the structure of the market, students are not forced into one role In many classroom market simulations, students are given specific duties such as investor, market maker, speculator, or trader The UIBX pit-trading structure allows students to form an opinion and take positions Some students will become traders, speculators, arbitragers, hedgers, or a combination

6 While one central clearing house is needed for the orderly flow of quotes, students have the ability to form opinions and act on them Students that understand the Bid-Ask spread will be more involved as traders They will post bids and offers in most of the contracts and try to profit from the spread Ideally, they can buy low and sell high many times and keep the difference This is sometimes referred to as scalping, and it happens in actual markets every day This type of market participant helps keep the Bid-Ask spread small and aids other participants in getting their orders filled Generally, scalpers will not care what contract they hold at the end of the market session, they only want to collect the difference between the Bid-Ask spread Traders will usually need to have high volume and will be in the center of the action Again, pre-assigned roles are not needed given the structure of the market, students will act on their opinions and roles will be naturally filled Speculators are also an important part of the market Students that have formed a very strong opinion about the upcoming Fed announcement will become speculators and will use their initial deposit to slowly purchase contracts they want and sell contracts they do not want For example, if a speculator forms the opinion that the Fed will not change rates, then over the course of the trading section they will purchase A contracts and sell all other contracts If several speculators have formed a very strong opinion on the same contract, the price of A will increase given the limited supply and strong demand for the A contracts Once these traders have purchased their desired contracts they generally hold them until expiration in hopes of collecting the full payout However, most price movement will come from this group as they rebalance their portfolios to sell undesirable contracts and purchase desirable contracts Hedging is an important concept in modern day finance If a trader stays perfectly balanced on all contracts they will break even since one contract will pay $1 and all others will be worthless This assumes that the trader entered the market at the start by purchasing bundles for $1 which would make the four contracts have a cost basis of $025 each If a trader becomes out of balance due to supply and demand, they will need to hedge quickly and become balanced on all contracts Speculators will hedge depending on their conviction levels If a speculator likes contract A but is only 80% certain that this event will occur, they may hedge by purchasing a small amount of B contracts In the event that B occurs the speculator will limit their losses For example, trader DKM (see Exhibit D) anticipated a 50 basis point rate cut for the March 18, 2008 FOMC meeting They invested seventeen dollars (ie, bought 17 bundles) and therefore owned 17 of each of the A, B, C, and D contracts They traded to be able to buy C contracts (50 basis point cut), but also sold some contracts for cash and retained some of the B and D contracts so that they would only lose a small amount if their prediction of the FOMC s action was not accurate Had the C contract won, they would have had a $2027 payoff ($327 profit) As it turned out, the actual rate cut was 75 basis points, but they had retained six D contracts plus some cash so their payoff was $1427 ($273 loss) FOMC DECISION PROBABILITIES It has long been argued that markets are the best predictor of future events While this is not the main focus of the paper, it is a key piece that can be used in class discussions The IEM, UIBX and CBOT trade contracts can easily show predicative probabilities UIBX and IEM winner-takes-all markets consist of several contracts that sum to $1 Since the individual contract is either worth $1 or $0 at expiration the price of the contract in the open market is the current probability that the individual contract will pay $1 at expiation This is a very simple way

7 to extract contract probabilities An alternative probability estimate is published daily by The Cleveland Federal Reserve, using the CBOT s binary options Federal Funds Rate contracts These CBOT option contracts are similar to the UIBX and IEM style contracts in that they will pay a fixed amount ($1,000) if the option finishes at-the-money or in-the-money, and nothing otherwise For example, if the current Fed Funds Rate is 2% then the at-the-money options are the 98 Call and 98 Put Keep in mind that the contract is a par of 100, (ie, Fed Rate = Strike) If the Fed does nothing and holds rates the same, both the 98 Call and 98 Put will be worth $1,000 However, if the 98 Call is currently trading for 060, then the probability of a rate increase is 60% A rate increase to 225% would place the 98 Call in the money and pay $1,000 at expiration It doesn t matter how far in-the-money the 98 Call becomes, it will still only pay $1,000 Thus, if the 98 Put is currently trading at 020, then the probability of a rate cut is 20% For the 98 Put to pay the rate must be 2% or lower at expiration The current market is showing a 60% chance the rate will be increased to 225%, a 20% chance the rate will decrease to 175%, and the remaining 20% is the probability that the rate will stay the same Similar probabilities can be extracted from the UIBX contracts Since there are four contracts where one contract will expire in-the-money (and pay $1) and all others will expire out-of-the-money (and pay zero), the price for the contract represents the implied probability for that state of nature In this market it is recommended that the either the last trade or the Bid-Ask midpoint be used to indicate probability since the Bid-Ask spread can be large in some cases SURVEY RESULTS To measure our progress in meeting the learning objectives of the project, we gave students a questionnaire to find out about their experience The responses were on a five point scale (5 = strongly agree, 0 = strongly disagree) The questions and the average response are reported in Exhibit E ~EXHIBIT E~ The first question measures the level of enjoyment students got from participating in the exercise This received the highest of all the responses with an average of 485 Consistent with Simkins (1999), Holt (1996), and Bergstrom and Kwok (2005), we also found that students had significantly positive perceptions about their learning experience for pit trading mechanics and strategies Specifically, students felt that they had a better understanding of how the mechanics of pit trading works (Q2, which scored 468) In addition, they felt less satisfied with the ending structure of their portfolio (Q4, which scored 438), but they also had a better idea of what their strategy would be if they played the game again (Q3, which scored 468) We interpret these last two items as indicating that significant learning had likely taken place as a result of the pretrading lectures and, especially, the actual pit-trading experience The results were less strong with respect to how closely they followed the Federal Funds market and their opinion about FOMC actions (Q5, which scored 355, and Q6, which scored 364, respectively) Our interpretation is students at this level are already familiar with the FOMC and their role in the Federal Funds market, so their learning event is less dramatic than it is with pit-trading markets which they are basically experiencing for the first time Moreover, the time and effort required to learn the mechanics of pit-trading, as well as the related concepts (such as arbitrage, hedging strategies, speculation, etc), moved the focus of the more familiar FOMC process to the background Still with scores in the 35+ range for both of these questions,

8 we feel that students engaged in some meaningful level of examination and analysis for the FOMC market, and that this was reflected in the prices that they paid for the respective contracts CONCLUSION The University of Idaho Barker Exchange experience was designed to allow students to study the federal funds markets while simultaneously learning about IEM style contracts, the process of market determined probabilities for rate change expectations, and the structure and mechanics of pit-traded markets Student enthusiasm for the topic was very high, and there is some evidence that the combination of technology, experiential learning, and preparatory lectures were successful in generating significant learning outcomes for the students REFERENCES Bergstom, Theodore C, Eugene Kwok (2005), Extracting Valuable Data from Classroom Trading Pits, Journal of Economic Education, v 36, n 3, pp Bondarenko, O, and P Bossarts (2000) "Expectations and Learning in Iowa", Journal of Banking and Finance, v 24, n9, p , Brüggelambert, G (2004) "Information and Efficiency In Political Stock Markets: Using Computerized Markets To Predict Election Results," Applied Economics, v 36, Forsythe, R, F Nelson, GR Neumann and J Wright (1992) "Anatomy of an Experimental Political Stock Market," American Economic Review, v 82, pp Gomme, Paul "Iowa Electronic Markets" Federal Reserve Bank of Cleveland, April 15th, 2003 Holt, Charles A (1996), Classroom Games: Trading in a Pit Market, Journal of Economic Perspectives, v 10, n 1, pp Oliven, Kenneth, and Thomas A Rietz, (2004) Suckers are Born but Markets Are Made: Individual Rationality, Arbitrage, and Market Efficiency on an Electronic Futures Market, Management Science, v50, n2, pp Simkins, S (1999), "Promoting Active-Student Learning Using the World Wide Web in Economics Courses", Journal of Economic Education, Summer 1999, Stix, G (2008) When Markets Beat the Polls Scientific American, v 298, n3, 38-45

9 EXHIBIT A Contract Trading Specs for the UI Barker Exchange (UIBX) Description Barker Federal Funds Futures are contracts that have a fixed payout based upon the target fed funds rate set by the FOMC for the contracts time frame Bundles The futures will be sold in bundles of four contracts Each bundle will be sold for $1 and will include one of each of the four contracts, one A, B, C, and D Once a trader has purchased at least one bundle, the trader may sell off each contract separately on the open market Only contracts will be traded in the open market Contracts One single contract will represent an action taken by the FOMC and will pay $1 for the corresponding action being taken by the FOMC A contracts represent a 25 bp cut in the target rate, thus all A contracts for that expiration will pay $1 All other contracts will be worthless and pay $0 Traders will not be allowed to short (borrow) contracts Trading Accounts Accounts can be opened with a deposit of $2 to $20 All accounts will operate on a cash basis, margin will not be allowed Each account is required to purchase one bundle and have no more than 30% of the initial deposit in cash when initially opened Minimum Price Move Individual contracts will move in $01 increments from $01 to $100 Market Access Market is open to all CBE faculty and students interested in learning about futures markets Last Trading Day Each contract will have an expiration date which will be set every six weeks based on the FOMC meeting dates Trading Hours All trading will be conducted in an open outcry trading session once every week, up to expiration Hours will be determined weekly and posted for all traders to view Currently, electronic trading is not available Fixed and announced at the first session for each FOMC meeting Settlement Contracts will be settled on the day of expiration after the FOMC has announced at 11:15 am pacific Cash from all contracts will be settled no later than five days after contract expiration and cash will be available at that time Trading Platform All trades will take place in an open outcry session once every week Orders will only be filled during open market hours Limit orders may be submitted via up to one hour before open trading begins Ticker Symbol 25bp cut: A 50bp cut: B 75bp cut: C ROM: D

10 Exhibit B Transaction Tickets Panel A: Example Order to Purchase a Bundle (Cost = $5 for 5 Bundles) BUY Bundle Order SELL Buyer/Seller ARB # of Bundles 5 Panel B: Example of Matched Buy/Sell Orders for a D Contract BUY SELL BUY SELL Contract Contract A B C D A B C D Buyer DKM Buyer DKM Seller BTB Seller BTB # of Contracts 5 # of Contracts 5 Price $062 Price $062 EXHIBIT C

11 Quote Board by Contract Bid A Ask Bid B Ask MSS XXL CCW JRB ARB JRB DKM ARB Bid C Ask Bid D Ask JRB DKM TNT RWR JON TWS NRD MSS LDI EXHIBIT D

12 Account Balances for Market Participants Trade Symbols Cash A B C D PAYOFF ADS ARB BJP BRP BTB CCW CHG CJK COL DKM EGG KRA KRI LDI LIN MDP MEL MSS MTW NAB NRD PKC REG RIC RWR TLK TNT TWS XXL JRB Clearinghouse Cash Balance 219 Market Capitalization 219 EXHIBIT D Responses to Student Survey

13 QUESTIONS: Q1: I enjoyed participating in the UIBX pit session Q2: I have a better understanding of how pit trading works after this experience Q3: After participating in the UIBX pit session, I have a better idea of what my strategy would be if I played the game again Q4: I was satisfied with the results of my trades and the structure of my portfolio at the end of the session Q5: I studied the Federal Funds market more closely than I would have if I hadn't participated in this game Q6: I have a more informed opinion about what I think the Federal Reserve will do at their next FOMC meeting because of my participation in this game Average Std Dev