Efficient Markets and Information Processing: A One-Hour Classroom Trading Simulation

Abstract

This paper describes the implementation of a one hour classroom trading simulation originally developed by the author when he was a trader at the Chicago Board of Trade. Pre-requisite student knowledge consists of market efficiency concepts, and the market making process. The simulation involves putting students into teams of 4 or 5 (7 or 8 teams maximum) which function as OTC dealers/market makers in a novel asset market. The students have intimate knowledge of certain characteristics of this asset, but not full information. The simulation begins when each team posts a bid and ask price for the asset which is displayed for all market participants. Trading commences as each team is allowed to make one and only one trade with a competing market maker. Trades as well as bid/ask spreads are posted by the moderator who also interjects with commentary tailored to the knowledge level of the students (active versus passive trading, market maker risk, long and short concepts, price discovery concepts). After each round of trading, the teams are allowed to revise their bid/ask spreads. Inevitably, students find that the effective bid/ask spread in the market narrows purely as a function of trading since no new information is provided. Depending on the class and students, variations can be introduced including informed outside traders ("Mr. Arbitrage"), economic releases and comments by the Federal Reserve Chairman (suitably vague, of course). These variations allow the students to see first hand the impact of new information on the market as bid/ask spreads widen, volatility increases and invariably there is "over-reaction" to information. The simulation concludes when the bid/ask spreads have effectively bracketed the "true value" of the asset known only to the instructor. The instructor concludes with a discussion of what it means for the market to "process information" as demonstrated in the simulation as well as reinforcing the concepts of market making, risk, market behavior and trading.

Keywords: Market Maker, specialist, market efficiency, dealer, bid/ask spread, simulation

JEL Classification: A22, A23