Step (2) Underlying Asset and Estimation of Volatility: Define the new underlying asset/index of your proposed derivative product. Provide detailed discussions, real data, and quantitative measure of your proposed new underlying asset/index. Your report and analyses should include all of the following steps:

· (2.A) Define the new underlying asset/index of your proposed derivative. Importantly, use real data to construct and measure the new underlying asset/index.

· (2.B) Explain: (i) whether the underlying asset/index is tradeable or non-tradeable,

(ii) whether the underlying asset/index is subject to volatility and uncertainty, and

(iii) whether the underlying asset/index is subject to market manipulation.

Discuss the economic characteristics (e.g., tradeable or non-tradeable, volatility and uncertainty, no market manipulation, etc.) of the underlying asset.

· (2.C) [IMPORTANT] Collect real data to estimate volatility (s) of the underlying asset/index of the proposed new derivative (options) contract. Provide the source of information of the data. Provide your interpretations of the estimated volatility (s).

Ø To estimate volatility (s), apply the “volatility model” in Blackboard using real data of the underlying asset/index.

Important Instructions: Collect real data for the underlying asset/index of your proposed derivative product. Importantly, use real data of the underlying asset (i.e., its value/price/index) and the “volatility model” in Blackboard to estimate volatility (s) of returns of the underlying asset. The estimated volatility will be crucial information to examine the uncertainty and volatility of the underlying asset of the proposed new derivative (options) contracts.²

Step (3) Design of Proposed Derivative (Options) Contract: Provide detailed discussions of the design and product specifications of your proposed new derivative contract(s).

Important Instructions: Your proposed derivative contract should be options contracts (including Call Options and Put Options) as you will perform option pricing in Step (5). In Step (3), explain the product design and specifications of your proposed new options contracts, including all of the following:

(i) Contracts: Call Options and Put Options (by default);

(ii) Quantity and unit of underlying asset (i.e., the contract size or multiplier);

(iii) Maturity date (e.g., maturity of 1-month, 3-month, 1-year, etc.);

(iv)  Determination of Strike Price (K) and different cases of “Moneyness”, i.e., cases where S > K, S = K, and S < K;

(v) Exercising policy (e.g., European options vs. American options, etc.);

(vi) Delivery policy (e.g., physical delivery (if applicable) or cash settlement, etc.);

(vii) Margin requirement and daily settlement (if any); any other considerations, etc. Important Instructions: Explain the reasons for your assumptions/specifications of the options contracts above. You may use data and numerical examples to support your assumptions/specifications of the new options contracts.

Step (4) Proposed Derivatives Markets: Discuss the derivatives markets of your proposed new options. First, would you recommend exchange-traded markets or OTC markets for your proposed new derivatives? Support your own recommendations with at least one (1) major reason or argument based on derivative theories/concepts.³

Second, provide detailed discussions of the major types of investors/traders who will be trading the proposed new options contracts, including all of the following:

· (4.A) Who will Long Call options? e.g., hedgers and/or speculators who will take

long position of your proposed new Call option contacts;

· (4.B) Who will Long Put options? e.g., hedgers and/or speculators who will take long

position of your proposed new Put option contacts; and

· (4.C) Who will Short Call options and Short Put options? e.g., market makers who will sell your proposed new Call option and Put option contacts.

Important Instructions: Discuss the major types of investors/traders who will be using the proposed new options contacts, such as: hedgers, speculators, arbitrageurs (market makers), etc. Explain why these investors/traders will be interested in trading your proposed new options and benefit from your proposed new options. Importantly, provide examples of investors/traders for each of the cases, including (4.A), (4.B) and (4.C) above.

Step (5) Option Pricing Models [IMPORTANT]: Apply quantitative option pricing models with real data to value your proposed new option contracts – i.e., demonstrate how your proposed new option contracts can be priced and hedged using option pricing models. For Step (5), complete all of the following steps:⁴

(5.A) Inputs and Determinants of Option Pricing [IMPORTANT]: Before applying option pricing models, provide the following inputs (including the numerical values of (iv), (v), (vi), (vii) and (viii) below) of the option pricing models. Also, provide detailed discussions of these inputs/assumptions:

ü (i) Type(s) of the derivative (option) contract (i.e., Call option and Put option);

ü (ii) Exercise/delivery policy (e.g., European or American style options, etc.);

ü (iii) Underlying asset/risk driver (i.e., current value of the underlying, S_O);

ü (iv) Exercise/strike/delivery price (K);

ü (v) Volatility (s) – an important variable for options; use the volatility (s) of returns of the underlying asset you estimated in Step (2);

ü (vi) Maturity (T) – based on the derivative contract design you proposed in Step (3);

ü (vii) Required risk-free rate of return (r) – assume annual risk-free rate of 3-4%;

ü (viii) Other inputs/assumptions (e.g., dividends (q) if applicable, etc.). Important Instructions: provide detailed explanations of all inputs and assumptions.

(5.B) Option Pricing Models [IMPORTANT]: Perform no-arbitrage pricing of your proposed option contracts by applying option pricing models. First, consider the following option pricing models such as the Black-Scholes-Merton Model, the Binomial Option Pricing Model, and/or any other relevant option pricing models (e.g., multi-step binomial model, etc.). Second, compute the no-arbitrage option prices (including both call and put options) using option pricing models. In your report, present the numerical results of the computed no-arbitrage option prices (including both call and put options) based on the inputs (data) in (5.A) above.

(5.C) Sensitivity Analysis [IMPORTANT]: Perform Sensitivity Analyses to demonstrate how the pricing of your proposed new option contracts (computed in (5.B) above) change with alternative values of inputs and assumptions used in (5.A) above.

Important Instructions: Your sensitivity analyses should examine how both call and put option prices change with respect to: (a) different/alternative values of Volatility assumption; and (b) different Strike Prices (different cases of “moneyness”).⁵ In your report, present your results of sensitivity analyses with summary tables and/or figures.

(5.D) Option Hedging [IMPORTANT]: Describe how the sellers (e.g., market makers) of your proposed new options can maintain a risk-free position by option hedging (i.e., the option sellers can sell options in the risk-neutral world).⁶ Your analysis should cover the following steps:

· Provide numerical example(s) of option hedging by computing the Greek Letters (e.g., Delta) and trading positions in the underlying asset for call options and put options respectively. Discuss how the option sellers (or market makers) can perform option hedging (e.g., Delta hedging) of the underlying asset.

· If Step (2.B) suggests that your proposed underlying asset is non-tradeable (i.e., an example of Incomplete Market problem), discuss how the option sellers can perform option hedging with non-tradeable underlying asset.

Step (6) Conclusion and Learning Outcomes: Provide a concluding section, which summarizes your key findings and learning outcomes of this financial innovation project.

In concluding section, discuss two (2) major lessons (learning outcomes) of this project, such as the new ideas/insights, concepts/theories, and tools/models you have learned from this research project.

Learning Outcomes: This assignment will provide experiential learning and applications of derivatives to achieve the following learning outcomes: Fundamental concepts of derivatives; research, analytical, and quantitative skills for derivatives research and policy analyses. Applications of derivatives theories and analytical frameworks in understanding the modern issues of derivatives markets. Strategic insights and creative solutions to derivatives markets and financial innovation.