Tuesday, April 5, 2011

Mind the Gap

A quote attributed to Yogi Berra (and others) says:
"In theory there is no difference between theory and practice.
In practice there is."
The primary goal of interactive learning tools, like trading simulations, is to bridge this difference and let students learn not only what the concept is, but also to learn to apply it and then understand whether or not it  works in practice.

At FTS, we take a specific 3-step approach to this and provide the necessary tools.  The steps are:
1. THEORY: typically taught by the instructor and covered in textbooks
2. APPLICATION: simple calculations and application to historical or current data
3. PRACTICE: the application going forward in time and using the concept to make actual decisions.

The third step is where the gap is ultimately bridged: if you can understand how to use the tool then you have a real, practical understanding of the concept.  

As an example, take the concept of duration, taught in most introductory finance and investments courses.
In step 1, you would cover the concepts (Macaulay duration, modified duration, dollar duration) and explain how these measure the sensitivity of a bond's value to its yield.  These are described in our online textbook at www.bondtutor.com.

Our approach to step 2 is covered in our modules.  These modules teach the use of duration (and convexity) in portfolio selection and interest rate risk management.  One module is a visual and interactive presentation of the concepts.   The concepts are explained and an interactive calculator lets you see the interest rate exposure as you change your position:

A second module does a historical backtest (for any so you can see how it would have performed; this picture shows you the tracking error for a specific strategy:

In step 3, you manage a bond portfolio going forward in time, so you do not know what will happen to interest rates.   This is accomplished with our real time trading project.  The built in analytics give you real time updates of the duration and convexity, what you have to decide is what duration exposure to take, how to rebalance, and so on.   The analytics are shown below for a simple case with four US Treasuries:

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