General guidance
The assessment for this unit is coursework assignment (80%) and two in-class MCQ exam tests (20%). The required minimum mark for Pass has been set at 40%.
This is an individual assessment. Whilst there is no objection to you discussing the content of this assignment with your peers, your final submission must be completely your own work. Plagiarism and copying will not be tolerated and may lead to subsequent penalties being imposed. This is an individual assignment and all calculations, analysis and narrative submitted must be your own work.
The assignment will require a considerable personal investment of time and effort.
Structure of the assignment
The assignment requires you to respond to three different requirements in a report format. The total word count (excluding numerical calculations and analysis to be provided in appendix) is 3000 words (± 10%). When determining the amount of effort and words (though suggested for each) for each section of the assignment it will be advisable to examine the weighting of the marks allocated to requirements. The recommended font size is 12 (Arial or Times New Roman) and round numbers to two decimal points. Make sure you cover all the requirements in adequate detail.
Submission of the assignment
All three requirements must be attempted and submitted in one document. You are advised to prepare your assignment in Word format and copy and paste contents from Excel in an appendix where spreadsheets have been used to support your work.
Your student ID number should be shown on each page of your assignment.
Your assignment should be submitted electronically via Moodle and you are advised to do this well in advance of the submission deadline to avoid any system related issues. Feedback on your assignment will also be provided via Moodle once the marking has been completed.
Marking of the assignment
The matrix on the following page has been provided to assist you in completing your assignment and is an indicative guide only, not a formal marking scheme.
Indicative marking guide
| 0 – 39%,Fail | 40 – 49%,Third | 50 – 59%,2:2 | 60 – 69%,2:1 | 70 – 79%First | 80 – 100%First | |
| Criterion 1 Mark: | Compare the features of different types of Derivative Contracts including forwards, futures, options and Swaps. | |||||
| Unclear comparison of the different derivative contracts. Lack of understanding of the different derivative contracts. | Some ability shown of accurately comparing different derivative contracts. Partial understanding of the different derivative contracts exhibited. | An ability shown of accurately comparing different derivative contracts. Understanding of the different derivative contracts exhibited. Explanations would benefit from more detail and justification. | A good ability shown of accurately comparing different derivative contracts. Understanding of the different derivative contracts exhibited. Explanations are well reasoned and some justification provided. | A very good ability shown of accurately comparing different derivative contracts. Understanding of the different derivative contracts exhibited. Explanations are justified and applied to the given context. | Excellent ability shown of accurately comparing different derivative contracts. Understanding of the different derivative contracts exhibited. Explanations are fully justified and applied to the relevant context. | |
| Criterion 2 Mark: | Assess the functioning of the markets for the different types of Derivative Contracts. | |||||
| Little evidence of assessing the functioning of the markets for the different types of derivative contracts.
| Coursework provides partial evidence of assessing the functioning of the markets for the different types of derivative contracts. Insufficient and/or inaccurate description and evaluation of different markets. | Coursework provides adequate evidence of assessing the functioning of the markets for the different types of derivative contracts. A fair description and evaluation of different markets provided.
| Coursework provides good evidence of assessing the functioning of the markets for the different types of derivative contracts. A good description and evaluation of different markets provided.
| Coursework provides very good evidence of assessing how markets for different types of derivative contracts function. Very good description and evaluation of different markets provided. | A high degree of critical awareness and skills are demonstrated in assessing the functioning of the markets for the different types of derivative contracts. Excellent description and evaluation of different markets provided. | |
| Criterion 3 Mark: | Evaluate the price and value of different financial derivatives using the No Arbitrage Principle. | |||||
| Lack of ability to evaluate the price and value of different financial derivatives using the No Arbitrage Principle. Errors in numerical analysis or confusion in application of theory. | Unsatisfactory work showing little ability to price and value different financial derivatives using the No Arbitrage Principle. Little ability to apply theory and do numerical analysis. | Satisfactory work showing some ability to price and value different financial derivatives using No Arbitrage Principle. Some ability to apply theory and do numerical analysis.
| Good ability to price and value different financial derivatives using No Arbitrage Principle demonstrated. The underlying pricing theory has been correctly applied and the numerical analysis are accurate as well as adequate. | An excellent work that fully meets the requirements with clear signs of appropriate application of theory. A high degree of critical awareness and analytical skills demonstrated. | The submission indicates an outstanding ability to price and value derivative contracts using No Arbitrage Principle. There is some evidence of additional reading around the topic. A very high degree of critical awareness and analytical skills demonstrated. | |
| Criterion 4 Mark: | Estimate the Price and Value of different types of Derivative Contracts using financial theory and mathematical models. | |||||
| No use of financial theory and mathematical models. | Some use and application of financial theory and mathematical models that are partially correct. | Satisfactory use and application of financial theory and mathematical models that are partially correct. No conclusions on pricing. | Financial theory and a number of mathematical models are identified and used correctly. Some relevant conclusions on pricing provided. | Financial theory and all the most relevant techniques identified and used correctly. Relevant conclusions made on pricing. | Financial theory and all the most relevant techniques identified and used correctly. Financial theory, models and calculations well explained. Excellent conclusions made on pricing. | |
Rock Investments & Eagle Foundation
Rock Investments is currently operating in the US and specialises in managing equity portfolios for different institutional clients. It relies heavily on using derivative contracts for managing the risks around the equity investments for the portfolios it manages for different institutional investors. As a junior analyst on the derivatives trading desk, you have been tasked to support your line manager at Rock Investments and write a report that he will use to prepare a presentation before the management of Eagle Foundation, one of its new institutional clients.
Question 1
Eagle has indicated interest in international investments in equity securities and has requested Rock to consider the UK equity market. Rock has indicated that such a portfolio would also require the use of different derivative contracts to manage risk and that generally it prefers to use exchange-traded derivatives to over the counter (OTC) contracts. Further Rock identified Intercontinental Exchange (ICE) and Eurex Exchange as the two potential organised trading markets to consider for trading derivative contracts for managing risk of Eagle’s potential investment portfolio.
Required:
- Compare exchange-traded and OTC derivatives. (8 marks)
- Identify the features of futures and options on BT Group listed on ICE and Eurex Exchange. Compare the differences between ICE and Eurex options on BT Group. (10 marks)
- Assess futures and options listed on both ICE and Eurex markets and the features of available derivative contracts on BT Group & recommend which market should be used for trading. (7 marks)
(25 marks)
(Word limit 800)
Question 2
As a junior analyst, you have been tasked by your line manager to prepare supporting calculations in your report for a presentation to be made before Eagle Foundation’s management. These calculations should essentially demonstrate derivative pricing using the No Arbitrage Principle. To do so, you choose to demonstrate the pricing of futures and options contract on BT Group listed on Eurex Exchange. The line manager also wants to understand more about risk neutral pricing and expects you to provide some explanation of the underlying concepts.
Required:
- Estimate the fair price of any BT Group futures contract on Eurex using the cost of carry model. You are required to cover the following too:
- provide (select and make assumptions) any missing inputs.
- explain all the inputs in your pricing model and justify each.
- compare the price from your cost of carry model against the actual price at the day close and explain any underlying reasons for the under-pricing or over-pricing. (8 marks)
- A). Estimate the prices of both a BT Group call and a BT Group put option trading on Eurex Exchange using two and three period binomial option pricing models as well as the BSM model. You must cover the following:
- provide (select and make assumptions) any missing inputs.
- explain all the inputs in your pricing model and justify each.
- evaluate whether the call and the put options are over or under-valued based on the price estimates from your calculations compared to their actual prices on Eurex Exchange. (12 marks)
B). For the two period binomial model, demonstrate that the estimated price of the call is fair using the hedge portfolio calculations over the two period and adjusting the hedge ratio accordingly. (4 marks)
- Estimate the value of the risk free bonds from the put-call parity using first the prices of calls and puts from the BSM model in 2 above and then the actual prices of calls and puts available from Eurex Exchange for the same calls and puts. Discuss the factors that could explain the differences in pricing across the two put-call parity calculations. (6 marks)
- Explain Risk Neutral behaviour and describe how it is different than Risk Averse and Risk Seeking behaviours in financial markets. Give relevant examples of each from financial markets. Why is derivatives pricing considered to be risk neutral? Explain. (10 marks)
(40 marks)
(Word limit 1,400)
Question 3
Though Rock Investments has a general preference for exchange-traded derivatives, the management of Eagle Foundation is interested in knowing more about the use of OTC derivatives particularly forwards and Swaps for managing the risks of their proposed investments in UK equities. Your line manager requires your report to cover this too.
Required:
- Explain the mechanics of forwards and swaps as well as their similarities and differences. Also provide detail discussion of the underlying credit risk in both types of contracts. (10 marks)
- Illustrate the pricing of a hypothetical forward contract on BT Group’s stock and how it can be used to manage the risk of the proposed investment. You will have to consider and choose the required inputs and make reasonable assumptions wherever required. Provide clear descriptions of all the steps in the process and a conclusion. (8 marks)
- Illustrate the pricing of a hypothetical swap contract involving Eagle receiving GBP Libor[1] and paying the returns on BT Group’s stock; assume an investment of £1,000,000, payments made quarterly for one year. For any missing Libor term rates, assume that the term structure of interest rates is linear and upward sloping. Provide detail descriptions of each step. (12 marks)
(30 marks)
(Word limit 800)
Note: There are five marks for report format (3 marks) and Harvard referencing
(2 marks).
Total Marks 100 (Weight 80%)
[1] https://www.global-rates.com/interest-rates/libor/libor.aspx