Requirement

You are asked to prepare a short report (more details on how this should look are given  later) on how you created the security (no more than 1000 words in total for all parts) to include:

1. A  brief explanation  of the rationale for selecting a company whose common stock (ordinary shares) will be used for the Option. It will need to be a publicly listed company on a suitable stock exchange, for which you have access  to appropriate data (at least 12 months of stock price history). In choosing your stock, given the structure of the Option, you need to explain and justify your particular choice of stock  for the exercise and, most importantly, why this company would make the Option appealing to investors in the security (i.e., risk characteristics, age, industry, and other such  factors).  You can choose  any exchange-listed firm in any market.

2. Apply your knowledge of financial engineering gained from the course to “price” up the Option for the company you have chosen using (a) a binomial tree option-  pricing model; and (b) where the pricing is based on current market conditions.  That is, you are to use financial market data related to your assignment's period.  Hence, if the submission date is April, you need to use current data for March-  April, although you will need to set a cut-off date to allow for modelling and writing up, as well as submission.  However,  key pricing variables, such as interest rates and volatility, should  be those applicable over the assignment  period.

3. Once you have the option value at each node, compute the Delta (Δ) by taking the difference between the “up” and “down” child values.

a.   Describe how you would establish a delta-neutral position at the start time (the Delta at the root node). Indicate the number of shares of the underlying you would buy or sell.

b.   As the stock price evolves at each step, determine which node your path lands  on. Recompute  Δ for  that   node  and  explain   how  you  would rebalance the hedge to maintain approximate delta neutrality.

c. Comment on Gamma: In a short paragraph, discuss how gamma (the rate of change of Delta concerning the stock price) can impact your hedging costs,  and  whether you  might  consider  additional  vanilla  options  to manage the curvature risk.

4. Implementing a dynamic hedge for path-dependent security, like a lookback option, can be challenging in a real-world trading environment. Discuss at least two key market  frictions—liquidity constraints, transaction costs, or margin requirements—that an issuer might face when hedging or offering such a product. Use academic references to support your answer.

You will need to build a quantitative model. This is likely to involve a spreadsheet or any suitably granular coding platform. The binomial   option-pricing model requires a minimum of 4 or 5 steps.

Think of the analysis here as a “conceptual model” of the structure that will allow you to vary the constituent parts to understand what changing the “mix” will do to the option’s price, performance, and risks. Copy and paste this analysis into an easily understandable format in the appendix of your report.  (This is not part of the word   count.)  Key considerations in so doing:

a.   The model should be self-explanatory to the reader, allowing them   to understand how it is constructed and what it represents (i.e., you need to add explanations to the spreadsheet to make   it  intelligible).  Simply  providing numbers alone or with inadequate explanations will result in lost marks. Hence, consider how such information should be presented to make it comprehensible as a stand-alone element.

b.   This model should include the binomial tree values, Delta calculations, and the dynamic adjustments in the hedge portfolio at each step, explaining the totality of the cash flows involved in the Option structure.

c.    Provide  a  brief  commentary  on  how  well  you  expect  this delta-hedging approach to  protect the writer or  holder  of the  lookback  option from  price movements,  and  the  potential practical limitations (e.g.,  transaction  costs, discrete rebalancing, liquidity).

d.   All steps must be fully explained.

Note: You cannot “borrow” one of the  many freely available option  pricing  models available online. I need to see how the option pricing was done at a granular level, so you will have to price the option and show how the price was calculated. This includes explaining where the input variables are obtained and why they are reasonable. (As previously stated, I am not expecting pinpoint accuracy in these; I want them to be reasonably in line with current market conditions when you priced the security.)

Things to consider

•    In undertaking your assignment, briefly explain the principal building blocks you use. However, detailed technical explanations of the various financial instruments used to create the product are not required, nor should they be included in an appendix. (The appendices are not included in the word count, but please keep them brief to avoid uploading issues.)

•   When writing  up  your  assignment,  consider  that  the  user  of  your  report  is  a financial professional who will be familiar with the building blocks you are using; therefore, these do not need to be explained. However, as detailed earlier, you must demonstrate how you constructed and priced the security based on current market conditions.

•    Please adhere to academic good practice and avoid forms of misconduct. All forms will be assessed for similarity.

•   Access to  Refinitiv-LSEG  will  be  provided  by  the  release  date  so  that  you  can

download your  common  stock.  You  should  be  familiar  with  the  process  from Assignment 1.

•    Please ensure that your exam number is on the front page of the report.

Guidance on writing your assignment

For this assignment, brevity and clarity are what are being asked for. Therefore, consider how to express your material to avoid ambiguities and loose writing, that is, precision in what you say is required. A general rule of thumb is that numbers should be presented to 2 decimal places maximum, unless otherwise obviously not possible or would lack sufficient detail. Marks will be lost for failing to ensure such quality matters.

In a financial  institution and work environment, “keeping things short” is the  norm, as already covered in the brief for Assignment 1, so it is not repeated here. In addition, the spreadsheet you copied to the appendix should not be overly complicated: it is designed to “illustrate” the principles at work in your financial engineering rather than determine an absolutely “correct” price for the security in today s market conditions, so you are allowed to use approximations if you explain the justification for these.

The spreadsheet must be intelligible to anyone who examines it  and ensure it is legible electronically! Therefore,  ensure  it  is  clearly  labelled,  identified,  and  annotated to explain its purpose (i.e., clearly headed and notated). Failure to make the spreadsheet intelligible will result in a reduced mark awarded, as the reader/assessor cannot follow how the model arrives at the valuation.

Please ensure that your written report has a suitably professional appearance. Marks will be deducted for a poorly written and presented report and/or a poorly formatted spreadsheet.

Producing a professional-level quality document is good practice for the tasks you may be required to perform once you graduate and work in financial services, or elsewhere. Or  in  the application  process  for  such jobs!  Hence,  use  business  language  and  the correct technical terms. You can assume the reader (your “audience” —see below) is a financial professional who understands all the terminology and ideas—hence, these do not need to be explained, you can go straight to the analysis and conclusions.

Here is an overview of the knowledge you will need for this assignment:

Genre knowledge (what you will write): A case study (which this report is, in effect) is a method of investigation that allows the writer and reader to gain a deeper and richer understanding  of an issue by examining the application of the relevant body of knowledge to the case.

Subject matter knowledge (what you will write about): Cases are good learning tools for  students  because  they  illustrate  principles  and  concepts.  You  will  need  a  good understanding of the case to address the topic successfully. You will also need a good grasp of terminology and concepts from the literature and the subject (i.e., derivatives as applied to financial engineering).

Rhetorical knowledge (who you will write for): Identify in your preparation who you are writing for (i.e., your audience). In your assignment, you seek to get your audience to agree with your analysis and conclusions by being logical, robust, and convincing in how you present your argument and/or analysis. Note that your audience may know more about the case than you do, so it is crucial to demonstrate that you have acquired sufficient  knowledge  to  present  a  well-informed  explanation  of  your  analysis  with justifications.

Writing process knowledge (how you will write): Adopting the appropriate tone and voice in your writing that resonates with your audience is essential. This includes the correct use of any specialist terminology. Nothing weakens a piece of writing faster than misusing technical terms.

You will need to paraphrase the underlying principles and concepts accurately, and, if applicable, document the source of your knowledge correctly. You will also need to present claims (also called thesis statements) effectively, support these claims with evidence, and explain how the evidence demonstrates a good example of your claim.