Constructing Internet Futures Exchange for Teaching Derivatives Trading in Financial Markets

Simulations and games are widely accepted as a powerful mode of teaching and learning. This is especially so in the field of finance in teaching students the intricacies of stock market trading. Stock market simulations complement more traditional methods of teaching finance by encouraging learning by doing, by generating motivation and enjoyment, and by engaging the business student in a simulated experience resembling the "real world." Although there exist numerous stock market simulation games on the Web, they are all "secondary simulations" in that the players cannot affect the prices of the traded securities but must take the security prices "as given" and base the trading simulation on these given prices. Such secondary simulations, however, lose an important dimension of market realism in that in the real stock market, players, especially "big" players such as major banks and large institutional investors, can influence the price of the traded securities. Secondly, being secondary simulations, existing internet stock market simulation games focus almost exclusively on stock trading and cannot realistically simulate the trading of derivatives. Compared to stock trading the trading of derivatives is a lot more complex both conceptually and from a teaching point of view. In this study, we leverage the power of internet technology and design a fully functional internet futures exchange. In our internet futures exchange, the prices of the futures contracts being traded is directly determined by the market participants (players). Additionally, our designed website tackles the difficult task of teaching derivative (futures) trading via learning by doing in a realistic trading environment with realtime feedback where traders can influence the price. Conceptually, this is superior to the use of secondary simulators (existing web market simulation games) where players must take the security prices as given and cannot influence its value through strategic behaviors. This is especially of importance for the teaching of derivative trading in as much as in the real world, powerhouses (large institutional traders) often exert significant influence on the observed derivative prices. With respect to academic research, we provide an example of the use of our internet futures exchange as a research platform to address the issue of market transparency and front runners. This, in itself is an important research question since market transparency level lies at the heart of controversial debates. Empirical data gathered from a controlled laboratory setting may help resolve the controversy. Previous laboratory studies addressing this issue use simplified representations of financial exchanges based on simulated securities whose values are chosen randomly form some predetermined distribution. For our study, we construct a fully functional futures exchange based on real underlying securities on the internet and conduct our experiments on this exchange. Our obtained results should be more robust than those obtained from simplified financial exchanges used in previous studies. We also analyze the relation between market transparency and front runners. No previous research has been done analyzing this issue in detail. In our study, we make use of our constructed fully functional internet futures exchange and gather empirical data under alternative exchange designs and varying levels of transparency and front-runner participation. The effect of varying levels of front runner participation on the bid-ask spread and on trading gains and losses can be tested for. Additionally, the effect of varying levels of front runner order quantity (order size) can be tested for.