Teaching Bond Valuation

I am struck by how different instructors use various parts of our system to teach essentially the same thing.   In fact, when someone asks how to teach something using our system, the answer mostly depends on your style of teaching.  This is hard to explain in the abstract, so let me give you an example. on teaching Bond Valuation.  A previous post shows you alternative ways to teach portfolio diversification.


The basics of teaching bond valuation include understanding discounting and the price-yield relationship, the term structure of interest rates, spot and forward rates, and perhaps managing interest rate risk using duration and convexity.   These topics are taught in at least 3 different ways:

Method 1: Bond Tutor - This is an interactive textbook; calculators are embedded into the online text, and students can experiment with concepts  as they learn about them.  For example, students can change the yield curve or forward curve, and observe the effect on the other curve and also on bond values:
 

Method 2: The FTS Interactive Markets-  Here, students trade bonds and learning takes place through price discovery and by building an analytical support system to help their trading.   In the simplest case (B01), there is a flat yield curve, so you learn how to discount given a yield.  Students who do not discount correctly lose money in the trading exercise to others.   Cases B02 and B03 introduce spot rates and forward rates.  Case B04 requires them to hedge a bond portfolio using duration.  Subsequent cases build on this, and the most advanced have trading of swaps as well as caps and floors to manage interest rate risk.  This is a synchronous “in class” exercise; students trade with each other, they react to each other.  Learning goes beyond a textbook; you need to understand the concepts, but you also learn how to use the concepts in making a trading decision.  The biggest way in which they lear is by building a decision support system in Excel.  The Student Case Preparation Manual shows you what students have to do to prepare for the case and how the learning takes place.  The following screen shows a real example of the FTS Interactive Trader with trading case B02:

Method 3: The Real Time System- The textbook and interactive markets are great teaching tools, but they do not let you experience some of the complexities of managing a real world bond portfolio.  The FTS Real Time system, with its built in analytics, provides some of this experience.  Here is a sample screen (of the Windows) of our Duration and Interest Rate Risk project

You can see my position in two bonds, and importantly, the portfolio analytics at the bottom right, and these analytics are used by students to make trading decisions.  

Summary These methods are not exclusive, and my description of what is available is not exhaustive (see below).   Bond Tutor represents the smallest deviation from a traditional textbook.  The FTS Interactive Markets are short trading exercises and it is easy to introduce the trading exercise in class and conduct a discussion that relates the concept to the trading exercise and also to markets and price discovery.  The FTS Real Time exercise abstracts away from price discovery but exposes students to application of the concepts to real-world interest rate movements.   

Just as an aside, we have several other modules for teaching fixed income; these include:

--The Treasury Calculator (the relationship between quoted Treasury prices and yields; yield curve approximations and interpolation; understand duration and convexity)

-- The Bond Immunization Lesson (a self contained interactive lesson for understanding how immunization works)

-- The Interest Rate Risk Module (Plot historical yields, spot rates, and forward rates, Animate curves to get a visual feel for long terms trends and mean reversion,  Calculate volatilities and correlations, Conduct principal component analysis, Backtest to understand the efficacy of different immunization strategies)

--The Principal Components Lesson (Understand the essence of principal component analysis with a visual calculator)

--The BDT (Black-Derman-Toy) Module (calibrate a BDT model to your own yield curve data using either yield volatilities or local vitalities, transfer the calculated lattice to Excel to price interest rate derivatives)

Experimental Research with FTS

Experimental research is a big part of our history.  In fact, the first version of the FTS Interactive Markets was developed in 1989 and 1990 for conducting experiments on information aggregation; the resulting paper came out in the Journal of Finance in 1991.  I even have a picture of the old text-based interface, on an original PS2 computer:

 

Since then, the FTS Interactive Markets have been used in many other experiments by different researchers.  Even today, we are helping several people with their new experiments; this includes setting up the trading parameters as well as software modifications to accommodate their needs. 

 

Beyond market experiments, though, we also have a “generic” experimental platform for conducting all sorts of experiments easily; these include behavioral experiments, auctions, and so on.   Examples of how to easily design eperiments are described in this document.

You can also use it to add non-market dimensions to a market; one example is adding a cheap-talk phase before a trading phase in a market, as in http://server1.tepper.cmu.edu/Seminars/docs/JobMarketPaper_0107_HongQu_CMU.pdf 

 

The experimental system is fairly straightforward. I’ll use an auction as an example.  You set up the experiment in an Excel workbook. One worksheet contains common information, such as instructions, sent to all subjects. Another worksheet contains information to be sent to individually, such as a private value or signal for the object being sold in an auction. This area also specifies what input is required from the subjects, such as a bid for the object being auctioned.

 

• You run the experimental server on your computer and connect it to your workbook.

• The subjects all connect to your computer using the client program.

• You send the common information

• You send the private information

• The subjects enter their responses (e.g. bids) during some period of time that you choose.

• When the time is up, you “grab” all their responses, calculate the outcomes in your

workbook (e.g. the price paid and who is allocated the object) and send this information

back to everyone.

 

The information flow described above can also be made continuous; in fact, you can mix and match

information that is updated constantly and that is updated manually. For example, if you are running a sealed bid auction, you only need to retrieve bids at the end of each round. If you are running an English auction, you may want to display the highest bid (or all bids) continuously.

 

The experimenter’s screen looks like this:

In the spreadsheet, you can set the colors of each cell, the text alignment, and you can see all the features in the screen shot.  We have a standard template that you can modify to create a variety of different types of experiments quickly and without a lot of effort.  If you have questions, please contact us, we love to talk about experimental research.

Portfolio Fundamentals

An exciting new capability is the integration of the Real Time System with Valuation Tutor (VT in what follows).  What it lets you do is conduct a fundamental analysis of your portfolio and also helps with stock selection.  I will describe the latter capability in a more general posting about using VT for stock selection.  Here, I will focus on the portfolio analysis.

Recall that in VT, you can analyze and compare companies along many dimensions.  These include common size analysis, cost-volume profit analysis, efficiency ratios, as well as price ratios.  Now, you can do the same for your stock portfolio.  This lets you answer questions such as: what is the ROE of my portfolio?  How does it compare to the stocks in my trading case?  How does it compare to specific industries or sectors?  And ROE is just one metric; you can compare your portfolio to any subset of stocks (in the VT dataset), sector and industry averages, and see exactly what are the fundamentals of your portfolio along any dimension covered by VT.

To use the capability, launch the FTS Real Time client and log in to one of our US Equity cases.  I will use the simplest case, the 30 stock case to illustrate the connection.  After you log in, click on the (new) Valuation Tutor tab:

 When you transfer the data, VT creates an (artificial) stock called “RT Portfolio”

Valuation Tutor

We have had some exciting developments with Valuation Tutor. First, we have added a lot of visualization and comparison capabilities.

 

You can read about these on the Valuation Tutor blog:
Financial Statement Analysis- The Power of Visualization
Financial Statement Analysis- The Power to Compare 
The capabilities are also described in the video at the top of this blog. Second, we have integrated Valuation Tutor with the FTS Real Time Client. I will soon post a description of this, together with an example of using Valuation Tutor for stock selection, so stay tuned!

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):

 The “normal” reports include daily market values compared to the benchmark, as well as a variety of performance measures.  We also show the rank of each student along various dimensions as you can see.  Note the “Export to Excel” button: you can transfer any report into an Excel spreadsheet by clicking this button.

The “Download Trade Activity” button lets you see who traded on what date.  This is critical when you need a project to start on a given date and end on a given date; you can monitor whether students are implementing their positions or not.

Beyond that, you can download the entire trading history of any student (buttons on the right hand part of the image).  This allows you to check their project reports against their actual trades.  You can also generate reports for a specific student once you have downloaded their history:

A students history is, of course, also available to the student; the instructor can additionally access request this for every student.  You can see every trade, a detailed replay of the the history of any security, and, perhaps most useful, the P&L reports.  These come in two forms: a summary report and a detailed report per security.  The following pictures give you an idea:

The detailed report shows you exactly what happened and when by security.

Of course, students are always interested in overall performance.   Here is an example of that report:

Ease of Access: SEC XBRL Filings

The world of financial statement analysis has undergone a dramatic change with the SEC’s Interactive Data requirement.   Effective June 2011, essentially all publicly traded companies “will provide their financial statements to the Commission and on their corporate Web sites in interactive data format using the eXtensible Business Reporting Language (XBRL)."  The SEC's goal in adopting this requirement is "to provide financial statement information in a form that is intended to improve its usefulness to investors. In this format, financial statement information could be downloaded directly into spreadsheets, analyzed in a variety of ways using commercial off-the-shelf software, and used within investment models in other software formats." (Source: sec.gov, Final Rule: Interactive Data to Improve Financial Reporting.)

At FTS, we have been busy bringing the power of the interactive data to our users.  Valuation Tutor now gives you immediate access, with easy search capability, to any interactive filing for companies traded on the major exchanges.  As of the time of this writing, over 9000 10-K's, 10-Q's, and 20-F's were accessible, and we expect to add roughly 5000 filings every quarter.  We are also exploring ways to provide access to filings in other countries, since our system is used in over 20 countries.

Market Microstructure

There are several different methods by which orders are submitted, displayed, and matched on real world exchanges.  There are usually three phases in a trading day: the time period before the market opens, the trading day during which the market is open, and then the time after the market closes.  Sometimes, different methods are used in each of the phases.  For example, many exchanges have a pre-opening call auction but continuous trading when the market opens.   There are variations even within each type.  For example, some exchanges display orders in the pre-opening call auction, some don’t.  Some display the “virtual price” (the volume maximizing price given current orders) and some don’t.  Some even have a random closing time.

The FTS Interactive Markets handle a wide range of mechanisms.  For example, you can run a pre-opening call auction followed by a continuous double auction.  You can run order-driven and quote-driven markets.  You can have competing dealers, who can or cannot trade for their own account.  You can even have traders who have to trade out of a position before they can trade for their own account.  You can hide or display the limit order book.  You can run a pure specialist market.  You can also have an “upstairs market.”

All the variations are listed at the link Microstructure treatments (the second part shows how you modify our trading cases to run a variation).  We also have pre-set cases that run through the variations.  Over the years, we have developed many cases for specific instructors; let us know if you want to modify a case.