Insider Trading Rings

Recent news stories about insider trading and the conviction of a hedge fund manager reminded me of a simulation we used to run that is just as relevant today.  This simulation is different from the ethics simulation I wrote about elsewhere in the blog. The ethics simulation focuses on the individual decision: when faced with the situation, will you make the ethical decision?  The insider trading simulation focuses on groupssharing insider information for mutual profit.

In the simulation, traders receive insider information about the prospects of a company.  Prior to trading, they are allowed to exchange messages; they can choose whom to communicate with, and if they receive a communication, they can choose to see it or not. They know who is sending them the communication.  After the communication, the stocks are traded in the FTS Interactive Markets; in these markets, the trader buy and sell the stocks from each other, and in the particular simulation, the trading mechanism was a double auction where everyone is a dealer, so they trade for their own account.  There were cash prizes for the best performers, and all the information they received from the system was correct (and so unambiguously useful). 

Meet Me On The Web

As the semester draws to a close at US universities, we receive many inquiries that require “interactive” meetings where we can either see someone else’s computer screen or where we can show them how to achieve some educational goal using our system.  We use GotoMeeting to conduct these meetings.  They tend to be of four types.  The first, and most common, is people who are thinking about adopting FTS in the future, and these meetings usually consist of an overview of the system and its application in different courses.  The second is from people using our system for experimental research.  The third, usually before the start of the semester, is from instructors asking how to integrate specific parts of the system in their upcoming course.  The fourth type is from existing users of the system asking “how can I do “ something related to the end of the semester, whether it is students asking how to create reports or instructors asking how to get particular information on student performance.

 

It struck me today, when a flurry of requests for meeting came in, that we actually do a lot of these and on a regular basis, specially at the beginning and end of each semester.  For example, I did a series of meetings in December and January for an instructor who wanted to design a specific type of market microstructure course; the course was taught this spring.  Other example is of meetings on experimental research

Greek Alphabet

No doubt about it, one area where a real-time simulation adds tremendous value is in the teaching of options.  Perhaps more than any other application of textbook finance, you really need analytics to make decisions and to appreciate the usefulness of the models.  

While there are many different exercises you can conduct, one of my favorites is one where students hedge the risk of a stock portfolio using index options, as described in our Hedging with Options real time project. We like using index options because we want to stress hedging on a portfolio-wide basis, not hedging individual securities by themselves (which would over-hedge the portfolio).

This introduces many concepts beyond basic option pricing and hedging: you have basis risk since you don’t have options on your portfolio, you need to understand correlations between the stocks (and whether these are stable), and of course you have to decide how to rebalance.  In this exercise, the equity positions don’t matter; the question is after you take the position, can you effectively hedge the price (and/or volatility) risk?  Variations of the project have options on smaller and larger equity indexes, and you really only need positions in one or two stocks to create an interesting problem.  As an extension, you could add index futures as well.  These types of projects also have the added advantage that to draw realistic conclusions on hedge performance, you only need a short period of time, say a week or two, so they fit in well into course timetables. 

 

In such a project, each student can use their own estimates of parameters (such as risk free rates and volatilities), though we provide default values.  All the analytics can also be calculated using implied volatilities.   In real time, you see both the individual and portfolio-level Greek parameters; aggregation is calculated using beta weightings, as done in practice and as explained in the project writeup.  There are three main analytic screens.  The first shows the Greeks at the portfolio level:

 

  

Caught Short

Short sales can be confusing for students in several ways.  First, they are unintuitive, perhaps because most of their experience in life consists of buying things or selling something they already have.   Second, the concept of a portfolio weight is not as clear as for long positions, and there are at least two ways to define them.  Third, the margin requirements of short sales can be counterintuitive: you are selling something but don’t get the money; in fact, you have to put up additional money.  If they don’t understand this third point, they can run out of money when trying to implement a strategy.

All this comes together in our Portfolio Diversification project where we explain the issues involved.  The project forces them to work through and understand the issues.  The real-time analytics they use to monitor their positions reinforce this, for example:

Report to the Instructor

As we near the end of the semester, I thought I would describe some of the capability available to instructors for evaluating student activity and performance in our real time system.  As I have written elsewhere in this blog, our emphasis is not just on performance, it has much more to do with the practical implementation of principles of investments.  So the market value or the Sharpe ratio may only be a small part of what is needed for a full evaluation.

An instructor can obtain the complete history of every student at any time by selecting “Instructor Reports” from the Reports menu item:

 

 The resulting window gives you everything you could conceivably want (I have hidden the actual numbers in the next picture since these are real accounts):