# DERIVATIVES MARKETS

DERIVATIVES MARKETS

IMPORTANT INSTRUCTIONS:
? This document provides the instructions of Individual Research Assignment –
PART II. The individual research assignment should be individually and
professionally prepared.
? All analyses and results should be original and based on your own analyses and
findings. Any reference and source of information should be explicitly provided.
? Please complete ALL parts of the Individual Research Assignment, and provide
your discussions and analyses as clear as possible. Summary tables of statistics,
quantitative analyses and qualitative discussions should be included in your
report.
IMPORTANT REQUIREMENTS:
Individual Research Assignments should be your original work, and all parts of
the assignments should be prepared and done all by yourself. No group work
and collaboration will be allowed for individual assignments. Failure to follow
these requirements may result a final grade of an “F”. You must complete the
following email: [email protected] by the due date.
IMPORTANT DATES:
? Due date of Individual Research Assignment Part II: Sunday, December 7th,2014
IMPORTANT NOTE ON ELECTRONIC SUBMISSION:
? Please submit electronic files of ALL parts of your assignments (including the
reports, spreadsheet models, references, and other files) to the following email:
[email protected]
Question #1 [Option Pricing Models]
The spot price of VXX is \$30 (i.e. S0
= \$30). The volatility of VXX is 25% (i.e. ? =
0.25). We are valuing the option on VXX with time to maturity of 1 month (i.e. ?t
or T = 1/12). The risk-free rate with continuous compounding is 4% per annum (i.e. r
= 0.04). Assume that there is no dividend for VXX.
Part (a) [Arbitrage Portfolio Approach]
Calculate the value of a 1-month European Call option on VXX with an exercise price
of \$29 (i.e. K = \$29). Use Arbitrage Portfolio approach with one-step binomial tree.
Note that:
Part (b) [Risk-Neutral Valuation Approach]
Use the Risk-Neutral Valuation approach to calculate the value of option in Part (a).
Part (c) [Black-Scholes-Merton Approach]
Calculate the value of a 1-month European Call option on VXX with an exercise price
of \$29 (i.e. K = \$29), using the Black-Scholes-Merton option pricing formula and the
assumptions given above (i.e. S0 = \$30; ? = 0.25; ?t or T = 1/12; and r = 0.04).
Calculate the value of a 1-month European Put option on VXX with an exercise price
of \$29 (i.e. K = \$29), using the Black-Scholes-Merton option pricing formula and the
assumptions given above (i.e. S0
= \$30; ? = 0.25; ?t or T = 1/12; and r = 0.04).
Part (d) [Implied Volatility]
Assume that the market price of option on VXX = \$2. Calculate the Implied Volatility
of this 1-month European Call option on VXX with an exercise price of \$29 (i.e. K =
\$29). To calculate the Implied Volatility, please use the following assumptions: S0 =
\$30; K = \$29; ?t or T = 1/12; and r = 0.04. Hint: you may use the
Black-Scholes-Merton option pricing model (e.g., implied volatility model at
Blackboard) to solve the implied volatility.

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Question #2 [Case Study of Real Options]
Prepare a 2-page minimum (1½-spaced paragraphs) case study of Real Option.
Construct a Real Option model in any setting of strategic and dynamic decisions
under risks and uncertainties (e.g. decision to expand/shutdown a project, decision to
make R&D investments, dynamic corporate financing decision, education/career
decisions, and other strategic/dynamic decisions under risks and uncertainties, etc.).
Provide detailed and specific discussions about the nature of the Real Option problem,
the underlying parameters of the Real Option model, and how you apply the Real
Option model for valuation and dynamic decisions under risks and uncertainties. You
analysis should follow the step-by-step Real Option approach below:
Step (1) Real Option Identification.
Identify your Real Option problem. Clearly define the structure of your problem/case
study and explain why it can be framed as a Real Option problem (e.g. discuss the
‘optionality’ of your proposed problem and how Real Option can help to value and
understand your proposed strategic and dynamic decisions under risks and
uncertainties). Importantly, provide explicit discussion and analyses to demonstrate
Step (1.1) Real Option Application.
Identify the major Real Option parameters, which include:
? (i) Type(s) of the Real Option;
? (ii) Underlying asset/risk driver;
? (iii) Exercise/strike price;
? (iv) Volatility (Important variable for Real Options – please provide detailed
explanation and analysis to estimate the volatility of Real Option). Important note:
apply the spreadsheet model of estimating volatility (see Blackboard) with
realistic assumptions and actual data;
? (v) Maturity and exercise strategy;
? (vi) Required risk-free rate of return (suggestion: you may assume 3-4% or other
risk-free rates of returns).
Provide detailed and clear explanations of your Real Option assumptions and
parameters.
Step (2) Real Option Valuation
Construct a Real Option valuation model that can analyze your problem. Please
complete all of the following steps for Real Option Valuation: 4
Step (2.1) ‘Benchmark Case’ with NPV
Start with the NPV method by valuing the project as if there were no option involved,
i.e., the “benchmark case” as if all decisions had to be taken immediately without
flexibility. As an important part of your analyses, demonstrate why your proposed
Real Option model is better than traditional valuation methods such as the NPV
method (see, e.g., the examples of Real Options provided in the lecture).
Step (2.2) Real Option Model
Construct a Real Option model (using the Real Option parameters you identify in Step
(1.1) above) to analyze your problem. To provide valuation of the Real Option, you
can consider the following models:
? Binomial Option Pricing Model, and/or
? Black-Scholes-Merton Model, and/or
? Any other relevant option pricing models (e.g. multi-step binomial model,
trinomial model, stochastic volatility model, jump diffusion model, etc.).
Step (2.3) Sensitivity Analyses [Important Step]
Provide sensitivity analyses and simulations of your estimated Real Option value to
evaluate different possible outcomes/results of your Real Option model. Consider
alternative values/parameters of assumptions used in Step (1.1) above, and perform
sensitivity analyses and robust tests of your Real Option model. For example, you can
perform sensitivity analyses of Real Option value using different values of volatility
assumption (for examining Vega), etc. Note that this is an important step to complete
the Real Option analyses.
Step (3) Interpretation and Conclusions
Summarize the key insights and results obtained from your Real Option model.
Discuss how your Real Option model can provide better valuation and
decision-making for your case study. Provide a conclusion based on the key
findings and learning outcomes from your Real Option analysis. In concluding
(i) Key original findings, insights, and implications of your Real Option case.
(ii) Key learning outcomes such as new ideas, concepts, tools/techniques, and
implications you have learnt from your Real Option applications.
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Important Instructions and Evaluation Criteria:
All analyses and discussions must be original, rigorous, well-organized, concise, and
integrated with frameworks and tables/figures of numerical results. Explain and
present all your assumptions, calculations, and ideas as clear as possible. Summary
tables/figures of numerical results should be provided to support your original
analyses and findings. Please make sure that you provide citations and complete
references of any sources of research, information and data used in your report; e.g.
provide reference of information from different sources of research. Your report may
include an Appendix that contains any additional information used in your analyses.
Individual Research Assignments should be your original work, and all parts of
the assignments should be prepared and done all by yourself. No group work
and collaboration will be allowed for individual assignments. Failure to follow
these requirements may result a final grade of an “F”. You must complete the 