Guidelines for Derivatives (M) Assignment 1 (20%)

IMPORTANT   : collect daily stock and option prices! PREAMBLE

In your EVA assignment, you were required to first select three stocks from each of the six sectors (with the sectors allocated according to the last digit of your student number).  These stocks were selected on the basis of their positive P/E ratio (restricted to no greater than 40) and of similar market capitalisation within the sector. You were then required to select one stock (out of the initial three) from each sector that represents the best valuation potential according to P/E analysis.  You are required to use this portfolio of six stocks for your Derivatives (M) Assignment 1.

In the event that some or all of these six stocks do not have options traded, you may be able to do one of the following:

1. justify the use of one of the other two stocks (from your initial three stocks in the same sector) as proxies and hence use options for this proxy stock instead.
2. justify the use of a newly identified stock from the same sector(s) as proxy and hence use the options for this proxy stock(s)

iii.      justify the use of index options

1. GROUP COMPONENT (5 marks)

2. a. Determine portfolio return and evaluate stock selection methodology (2.5 marks)

Compare current value of portfolio to cost. Consider what is an appropriate measure of return – nominal/real/risk adjusted? Think also about comparison benchmark, dividend consumption/reinvestment.

Discuss feasibility of PE ratio as a stock selection method. Think whether PE ratio (earnings smoothing, time lag and horizon, discount rate etc) is a good predictor of stock market returns (mean reversion, economy and market factors, behavioural biases) – some research is required.

2. Determine portfolio risk and evaluate “buy and hold” strategy (2.5 marks)

Determine your portfolio risk.  Think volatility of the portfolio value during your holding period, trading range, value at risk etc. Consider in the light of general market conditions and companies’ specifics.

Discuss feasibility of “buy and hold” strategy in the light of your risk assessment.  Consider transaction costs. Think also relevant theories such as EMH and Random Walk, active vs passive risk management – do some research.

1. B. INDIVIDUAL COMPONENT (15 marks)

1. a. Fully hedge the portfolio value at the desired risk level

Analyse market conditions and companies’ specific conditions during your holding period and give reasons for your full hedge strategy.   Justify the selection of risk threshold. Consider factors such as market volatility, companies’ specific risk, personal risk tolerance etc.

(5 marks)

Students need to clearly state the objective(s) of the full hedge.  Establish the strategy based on the proposed objective(s), justify your choice of options and strategy to be used.  The strategy should include the types of options to be traded, direction of trade, position size, contract specifications etc.  As you adopt this strategy after having determined your returns in 1a above, you should use option prices of the same day as 1a.

(5 marks)

At the conclusion of the two weeks period, evaluate the effectiveness of your full hedge. Assess if your objectives have been met and explain the reasons for its success or failure.  Consider hedging imperfections, suitability of strategy, changes in market conditions etc.   With the benefit of hindsight, discuss how improvements to the outcomes may be achieved. Think Greeks, vertical/horizontal spreads, alternative strategies etc. Calculations are required to support your discussion.

(5 mark)

1. Partially hedge the portfolio value

Analyse market conditions and companies’ specific conditions during your holding period and give reasons for your partial hedge strategy. Justify your selection of stock(s) and hence the value of portfolio to hedge. Consider factors such as market volatility, companies’ specific risk, personal risk tolerance etc.

(5 marks)

Students need to clearly state the objective(s) of the partial hedge.  Establish the strategy based on the proposed objective(s), justify your choice of options and strategy to be used.  The strategy should include the types of options to be traded, direction of trade, position size, contract specifications etc.  As you adopt this strategy after having determined your returns in 1a above, you should use option prices of the same day as 1a.

(5 marks)

At the conclusion of the two weeks period, evaluate the effectiveness of your partial hedge.  Assess if your objectives have been met and explain the reasons for its success or failure.   Consider hedging imperfections, suitability of strategy, changes in market conditions etc. With the benefit of hindsight, discuss how improvements to the outcomes may be achieved.   Think Greeks, vertical/horizontal spreads, alternative strategies etc. Calculations are required to support your discussion.

(5 mark)

1. Stocks substitution strategy

Analyse market conditions and companies’ specific conditions during your holding period and give reasons for your stocks substitution strategy.  Justify your selection of stock(s) to be liquidated and substituted with options. Consider factors such as market volatility, companies’ specific risk, personal risk tolerance etc.

(5 marks)

Students need to clearly state the objective(s) of the stocks substitution strategy.  Establish the strategy based on the proposed objective(s), justify your choice of options and strategy to be used. The strategy should include the types of options to be traded, direction of trade, position size, contract specifications etc.  As you adopt this strategy after having determined your returns in 1a above, you should use option prices of the same day as 1a.

(5 marks)

At the conclusion of the two weeks period, evaluate the effectiveness of your stocks substitution strategy. Assess if  your  objectives have  been  met  and  explain  the  reasons  for  its  success  or  failure.    Consider  hedging imperfections, suitability of strategy, changes in market conditions etc. With the benefit of hindsight, discuss how improvements to the outcomes may be achieved. Think Greeks, vertical/horizontal spreads, alternative strategies etc. Calculations are required to support your discussion.

(5 mark)