Welcome to the 14 th McIntire Hedge Tournament

1. Welcometo the 14th McIntire Hedge Tournament Rules of the TournamentOfficial source – Do not print!(c) 2002-2014 Stefano Grazioli & Bill Wilhelm

2. Outline • Tournament Objectives • Trading • Accounting • Technology • Recommendations • Read the hidden slides!

3. Learning Goals • Help you learn GENERAL & VALUABLE skills that will help you in your career • How to use IT to solve business problems • Thinking algorithmically • Accessing enterprise data • Mastering Excel automation • Specific IT & Finance Skills • Design and implement financial strategies • Hedging

4. When?Apr 23th, 5:00pm-9:00pm (possible delays). Where?McIntire Financial Center & Lab (reserved). Who?Teams of 1-3 (max) Why? It substitutes for the final It is an opportunity to learn valuable Finance and IT skills. Winners will get an A+ It is a great story to tell recruiters. Logistics

5. I assume that you are in option #3 until you tell me differently in writing. Option choices are final. Only declared teams can do team submissions. Teams (Grads)

6. Teams (4230) • Two or three people • Lone Wolves • Team Composition is due as soon as you want to do team submissions (no earlier than H15)

7. Still no Team? • Name • Year, School • Tournament attitude / team formation

8. Team Declaration • Email to Grazioli:We are team “Meltdown”:fhe6h, Mark Delltrophas7b, Mary Lundkwu92, Xiao Lee • Check on Collab for your TeamID • Submission MUST be named as in this example: “Team23.zip” or the TA will not know it is a team submission and you will not get a grade.

9. Team Roles You are a small Hedge Fund • Portfolio Manager • CIO/CTO • Rulemaster/COO • PM • Trader • Internal Auditor

10. Hedging Tournament • You will hedge an illiquid portfolio of stocks and options. That means that you will make investments to reduce the risk of adverse market movements in your portfolio. Typically, hedging is done by taking offsetting positionsin related securities.

11. Basic Architecture Initial positions, Market prices, Risk free rate… Fin. Data Feeds Fin. InfoPositions Your team Trades Updated Positions

12. Securities in the Tournament • about 12 Stocks • about 240 European options (n stocks x 2 types x 2 expirations x 5 strike prices)

13. List of Stocks • MCD • COF • GM • GE • AMZN • WMT • MKL • SAI • GNW • GOOG • NFLX • PG

14. Your Initial Portfolio (IP) • Stock and options on the companies included in the Tournament + Capital account (cash) • About $50 mil • You cannot change your positions on the tickers/symbols in your IP. That means that you cannot trade the symbols in IP. However, you must cash / pay dividends, and may exercise options as appropriate.

15. OBJECTIVE

16. Objective • Minimize liquidity risk while producing a target rateof return. This means keeping your Total Tracking Error as small as possible, ideally zero. • Total Tracking Error TTE = sum of all TEs, measured every Sunday. • Tracking Error TE = |TaTPV – TPV| if TaTPV > TPV(i.e., loss) |TaTPV – TPV|/4 if TaTPV < TPV (i.e., gain) • Target Total Portfolio Value TaTPVt = TPVatStart * ert • Total Portfolio Value TPVt = Capital Accountt + Portfolio Value(including IP) t

17. Tournament Winners • The team who at the end of the trading period has the Lowest Total Tracking Error wins the Tournament. • Official winners nominated during the next class. • Trade records will be audited. Rankingsmay change as a result of the discoveryof errors and irregularities. • Tournament grade depends onplacement, number and size of errors,and system quality. Many can do well.

18. TRADING

19. Transactions and Trades YOU ConfirmationTicket(next “day”, i.e. next minute) Transaction(trade) SYSTEM

20. Trade Execution • Trades are executed by posting a trade record to the server. • Trades are irrevocable Simplified Traderecord schema An example TeamIDTypeTicker QtyPrice TransactionCostTotCostOfTrade 14BuyMSFT 200 $40 $10 $8,010

21. Types of Transaction • Buy • Sell • SellShort • CashDiv • X-Put • X-Call • Only these six transaction codes are valid. • Copy exact spelling, including dashes, caps and spaces.

22. Trades • Trades are always made against cash • If you are selling:Qty * Bid price – transaction cost = + cash • If you are buying:Qty * Ask price + transaction cost = - cash

23. Transaction Costs • Depending on the type of trade, there is a transaction cost (a commission) to pay on each trade. • The TC table is in the DB Transaction cost = Cost Coefficient * (Qty * price) • No parameter value (e.g., cost coefficients, risk free interest rate) is completely fixed. Do not hardwire them in your models. They may change from HT to HT.

24. Trades – The fine print • Securities that are listed with a price of $0 cannot be traded. • You cannot trade twice the same ticker or symbol in the same day - i.e., no “money burning.” Both trades will be rejected.

25. Short Positions – The fine print • You can sell short both stock and options • there are margin requirements (discussed later) • You may not sell short if you have a long position on the same security • Example: you can not sellShort 250 GOOG if you hold a long position in 100 GOOG. First you sell the long position, then you go short. You must do so in two separate days. • If you have a short position in a stock and the dividend date comes, you need to pay dividends. • Treat it as a CashDiv transaction with a negative sign • If you have a short position in an option that is in the money at expiration, you need to honor it. • If not in IP, you can buy it back before expiration (easiest) • Before you exercise a short call (long put), you need to own the stock.

26. Margins • You must maintain cash margins = 30% of the current (mtm) value of all short securities in your portfolio • Margins change in time, because the mtm of the short positions that you hold changes in time. Thus, margins are reassessed after each trade • Margins (and thus the amount you can go short) are capped to a max $ value (e.g., $10mil). This MaxMargins value is found on the DB. • Step by step:Calculate z = S(qtyi * mtmi) for the short securities in your portfolio.The margins are = 0.30 * z, so make sure that your cash position after the trade is larger than z * 0.30

27. What To Trade? • That is the main job of the portfolio manager in each team: • Identify a good financial strategy • DELTA/GAMMA HEDGING + your mods is highly recommended • Basics will be covered in class – most will be your own ideas about financial strategy

28. ACCOUNTING

29. Bookeeping • You must maintain at all times an updated book of positions (“team portfolio”) on the server. • Portfolio update is done immediately after each trade. TeamPortfolio03 Exception: “Capital Account” is in $

30. Dividends • In $ • Paid quarterly • Not constant • Need to report them (as a transaction) : use “CashDiv” on the dividend date • The owner of the stock at the beginning of the dividend day gets the dividends • You do not get dividends from short stocks. You need to pay them on the dividend date!

31. Exercising Options Exercise them on the Saturday following the third Friday of the month of expiration • European options only: you can exercise them only on that Saturday • It is like buying/selling stock @ strike, and has a transaction cost • Can buy/sell options up to expiration day. • Cannot trade options that have a price of $0. • There will be no short options that expire in the IPs

32. Interest • Cash earns interest continuously • Just before every transaction compute the interest on the Capital Account • Interest = CAccount * ert -1 where t = time in years between the last transaction and this transaction. r= risk-free interest rate.

33. TECHNOLOGY • HedgeTournamentBETA and ALPHA will be on • f-sg6m-s4.comm.virginia.edu

34. DataBase Structure Data FeedsMarkets EconomicEnvironmentConditions Bookkeping Transactions

35. DataBase Structure (spr 10)

36. DB Scheme Read Read Read Insert Read Read Read Read Read Write Read

37. RECOMMENDATIONS

38. Recommendations • This is not your typical school project. This has to work for an extended period of time. • Outcomes is what matters (not program elegance or amount of work). • You are your own customer – I am here to help you, not judge you. • Have a plan B (and C) for everything that can go wrong.Redundancy. Management. • Leadership: Assign clear role & responsibilities and deliverables to team members. Monitor deliverables. • DO NOT trust your best programmer to get it done right and in time the night before. She/he will not. You will regret it. • Freeze deliverables. Version control. • Test, test, test, test.

39. Grounds for Penalties • Trading on non-current prices (minor) • Failing to accurately update the books after each trade (minor) • Failing to accurately report and account for transaction costs • Monitoring other teams’ activities • Failing to respect the margin cap • Failing to maintain the cash max margin (severe) • Letting the capital account go negative (severe) • Altering the records of another Team (most severe) • Hacking/disrupting the database,the server, or the network (disqualification)

40. Meet. Assign roles. Review the rulebook. Project mgmt class? Decide on a plan of action wrt the design of the software. Choose a team name and get access to the DB (email instructor and TA) Study the DB schema. Do you understand what each piece of data is? Gather all the formulas. Gather volatilities / decide where to get them from. Prepare test data: paper/pencil Test it (not the developer, somebody else). Figure out a trading strategy Figure out a starting strategy: what do to when you get those first (3pm) data. Understand your warm/cold start tactics Test everything. Simulate errors. Can you recover from a crash? Do a full simulation of the tournament. General System Test (participation) Suggested To Do List

41. Notes etc. • The rules are stable. No major changes are expected. Clarifications may occur as a result of my interaction with you. • Check this slide pack frequently for this symbol • If something is incorrect, let me know • Use the discussion forum on Collab • If in doubt, ask! Recentlyedited slide

42. Constants • Trading days / year = 252 • Year = 365.25

43. And the Winner is…. Your face here.