FIN7020 Derivatives Investments.

Learning outcome 1: Assess derivative contracts and their appropriateness and suitability for investment and management of different risks.

Learning outcome 2: Construct derivative contracts to get exposure to investments in different markets & asset classes.

Learning outcome 3: Evaluate different risks associated with investments & financing and use derivative contracts to hedge the relevant risks.

Question 1

A) You are currently working as a junior trader at the Derivatives Trading desk for Lambert Financials. Your line manager, Ray Donald, CFA, has asked you to prepare a short report comparing different option trading strategies. Ray has asked you to consider the costs for each strategy and its potential payoffs. You are not very comfortable with option models and must first investigate how to properly price European style equity options. Ray has given you choice to use any available option pricing model that you understand and can apply to price European puts and calls.

In order to complete the assigned task, you decide to use BSM model for pricing European puts and calls on Microsoft`s stock listed on the Chicago Board of Options Exchange (CBOE) . You have to choose exercises prices, expirations, risk free rate and measure of volatility to use as inputs in pricing the options.

Requirement:
I) Estimate prices of European puts and calls on Microsoft`s stock with two different expirations and two different exercise prices of your choice using the BSM model. Provide details of your underlying assumptions and inputs with justifications of each.

II) Illustrate Put-Call parity using any pair of the estimated call and put prices. You will have to bootstrap the value of risk free bonds.

III) Explain straddle strategy and demonstrate its execution using the puts and calls on Microsoft`s stock. Also calculate the following for the straddle assuming different spot prices for Microsoft`s shares at expiration:

a. Maximum profit.

b. Minimum profit.

c. Breakeven price.

IV) Evaluate the impact of different holding periods for the straddle constructed from options on Microsoft`s shares.

B) On the 9th of February 2021, one of your institutional client has committed lending £300 million in 70 days i.e. on 20th April 2021 for 180 days due on 17th October 2021. Interest rate is set to be 180-day LIBOR + 100 bps. The client is worried about a fall in interest rates over the next 70 days. However, the client wants to keep the upside.