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Secondary Bond Market Simulation with Financial Meltdown Shock

James Peyton, Highline Community College
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This material is replicated on a number of sites as part of the SERC Pedagogic Service Project

Summary

In this bond market simulation, students take the role of banks who are buying and selling bonds in order to make profits and meet their capital requirements while maintaining their total asset value. After two normal rounds, the potential risks to some of the bonds is revealed with the bonds that lose their value determined by the roll of a die at the end of the third round. After the third round ends, any banks unable to make their capital requirements can be "bailed out" by the instructor acting as the Central Bank. In the fourth and (optional) fifth rounds, the trading proceeds as in rounds 1 and 2. Setup documents and tracking spreadsheet included.

Learning Goals

Students understand how banks use bond trading to meet capital requirements and make profits while also needing to maintain a minimum bank total asset value.

Context for Use

This classroom simulation is appropriate for a principles-level macroeconomics class of up to 45 students. It complements money and banking content as well as credit markets and the Federal Reserve (Central Bank). It is designed to fit within a 50-minute face-to-face class for simulation and discussion, with additional time for further assessment. Setup time is approximately 1 hour.

Description and Teaching Materials

Structure:
9 banks
5 rounds (although simulation can stop after 4 rounds)

Materials
18 blue bonds to start (numbered small 1-6 on the back, 2 to each group), plus 13 orange bonds to start (see worksheet for distribution to groups)
40 x $10 million, 40 x $1 million (see worksheet for distribution to groups)
Instruction letters for each group (see examples in documentation)
10 letter envelopes (no.10) – 9 for groups and 1 for holding cash.
Spreadsheet to track end-of-round money for each group and the range of trade prices.
Die to roll to determine which bonds fail.
Timer to show round periods.
Individual student worksheet with tracking grid on one side, group discussion questions on the other.

Play
In each round some banks have excess reserves, some banks have capital needs.
First round is 2 minutes, second round is 1 ½ minutes, third and fourth rounds are 1 minute.
After each round, record ending capital reserves of each bank and the high and low values of trades. Announce the average of the high and low as the price to be used for calculating total cash and asset values. Pay $1 million for each bond held.
After 2 rounds, announce that some of the blue bonds are bad and that at the end of the third round, a die will be rolled to determine which ones.
Capital reserve requirements rise for the third round to put additional stress on the system.
At the end of the third round, record ending capital reserves and total asset values. Roll a die three times to determine which bonds are viewed as bad. Talk with the class about the situation, ask what the central bank should do. Offer to buy the "troubled assets" for $7 million each before noting any penalties for non-achieving groups.
Run round four (and optional round five) with the additional liquidity provided by the troubled asset relief.
Secondary Bond Market Simulation with Financial Meltdown Shock (Microsoft Word 2007 (.docx) 180kB Dec2 13)
Secondary Bond Market Tracking Spreadsheets (Excel 2007 (.xlsx) 14kB Dec2 13)


Teaching Notes and Tips

Student bankers have been very creative in meeting their capital and total asset requirements - they have loaned money, bonds, and charged interest to one another. While this creativity can lead to unexpected results, it also leads to some great discussion about bank-to-bank transactions. The bond prices can vary a lot.

Assessment

The discussion of the simulation through structured questions allows for an initial assessment of the learning that has occurred with the simulation. Further assessment is conducted through the inclusion of questions related to the simulation content on a subsequent quiz or test. Sample assessment questions would be "1. Explain how banks use the secondary bond market to make profits and meet ongoing capital requirements." and "2. Explain how uncertainty in the secondary bond market can cause problems for bank liquidity." This assessment can be linked to readings on the credit market problems that contributed strongly to the 2008-09 great recession.

References and Resources