Suppose that you are a derivatives trading expert with three years of experience at Interactive Brokers Group (IBG), an established leader in brokerage services. Along with normal brokerage activities, IBG has  also  been  providing  professional  fund  management  services.  You  have  been  given  the responsibility of handling the trading accounts of some individual clients. Due to the lack of time and expertise, these clients do not directly trade in stock and derivatives markets. Instead, they trust a brokerage company's trading expertise that provides them with customized solutions for hedging equity price risks. The management requires you to complete the following tasks, utilizing your in- depth knowledge of the markets and your derivatives trading expertise.

Task 1 (20 marks)

Any recommendation regarding option trading strategies requires understanding the behaviour of underlying  stock prices. In this Task, you are required to evaluate how the Rio Tinto Limited (RIO.AX)'s share price has performed over the last 2 years (i.e. from July 2020 to July 2022). Explore and discuss the primary reasons (e.g. company’s internal developments, the impact ofboth major world events and corporate events, etc.) for any significant trends or changes in its price that you have noticed over this period.

Note that your response needs to be backed by data/statistics/charts and supporting citations. Eikon should be your primary data source, which can be supplemented with datafrom the company's annual reports and other sources (if any). In your discussion, make sure to compare the relative stock price performance and volatility of the Rio company to its peers and the S&P/ASX 200 Index.

Task 2 (20 marks)

According to the Rio’s recent release of 2022 half year results, its net earnings were $8.9 billion, 28% lower than 2021 first half. This reflected the impact of the movement in commodity prices, the higher energy prices and the rising general price inflation on its operating costs and closure liabilities1 . With further risk of weaker demand for iron orea from top consumer China and challenges on labour shortages, assuming that you are bearish on the Rio share price. You also expect it comes with a moderate or high level of volatility in the next few months.

a) What are the two option strategies you would recommend to benefit from the bearish view on Rio? Explain your recommendation. Why would one be chosen over the other?

b) Using data information provided in Exhibit 1, construct numerical examples on each strategy for Rio options, to justify your decision and comparison of the two strategies discussed in Task (2a). Explain how the strategies will work, detail all transactions for undertaking the strategies and evaluate the outcomes of two options strategies at expiry.

Note   that   the  profit  diagrams   can   be   constructed  with   the   assistant   of   the  spreadsheet OptionStrategyAnalyzer10e.xlsm. You can use as much capital as you wish. Note that you buy options

at askprices and sell options at bidprices.

Exhibit 1: RIO option datafor 10th august, 2022 (observation date or strategy construction date)

Data source: Eikon

Task 3 (20 marks)

a) One of your clients, Mrs Ava Daphne currently holds a $2.47 million stock portfolio benchmarked to the S&P/ASX 200 Index. She wishes to maintain her current market exposure but would like to generate some extra returns above benchmark. The current price of S&P/ASX 200 Index is 7,022.7 and expected to be neutral over the next few months, probably ranging 30 points either side (i.e. between 6,992.7 and 7052.7).

In this Task, you will need to recommend one appropriate options strategy for her to exploit this neutral market expectation. Using data information provided in Exhibit 2, construct the selected strategy using S&P/ASX 200 options. Verify how this strategy will work, detail all transaction(s) for undertaking the strategy. Evaluate its outcome at expiry and assess how the outcome is compared to that of the benchmark (long-only) portfolio.

b) Mr James Alston, another client, does not hold any stock portfolio but would also like to speculate the neutral market outlook. Develop one options strategy (other than the strategy in part 3a) that can help Ms Miller benefit from the neutral view on the S&P/ASX 200 index. Using data information provided in Exhibit 2, construct the selected strategy using S&P/ASX 200 options. Explain how this strategy will work, detail all transaction(s) for undertaking the strategy. Evaluate its outcome at expiry.

c) Discuss the relative advantages and disadvantages of the two strategies selected in parts 3a and 3b.

Note   that   the  profit   diagram   can   be   constructed  with   the   assistant   of   the   spreadsheet OptionStrategyAnalyzer10e.xlsm. The multiplier on the index contract is $10. Note that you buy options at askprices and sell options at bidprices.

Exhibit 2: S&P/ASX 200 option data 10th august, 2022 (observation date or strategy construction date)

Data source: Eikon

Task 4 (36 marks)

Today is 10th August 2022, when the BHP Group Ltd (BHP.AX)'s share is priced at $38.56. Consider an BHP option that expires on 15th December 2022, with a strike price of $42. Assume no dividends are paid on this stock. The annual historical standard deviation of BHP stocks is 33.57%. The risk-free rate is 2.5628% with annual compounding. Ignore transaction costs (e.g. bid-ask spread).

a) Using a three-step (i.e three periods) binomial tree model, calculate theoretical prices today for i) a December American put option, ii) a December European call option, and iii) a December European put option on BHP stock.  Draw the trees and show all calculation workings at each node.            (10 marks)

b) For the December European  call option  (with the theoretical price  calculated  in  Task 4a): construct a hedge by combining a position in the stock with a position in the European call option on this stock. Show that the return on the hedge is the risk-free rate regardless of the outcome over each of thefirst two periods. You are also required to draw the tree with stock price, hedge ratio, value of a call and a hedge portfolio showing at each node (for thefirst two periods/steps only). Assume that the call sells for the theoretical value.                                                                                                     (8    marks)

c) Suppose that you observe that the market option price of December European put on this stock is currently $2.5. Is there an arbitrage opportunity? If you see an arbitrage opportunity, present a strategy to earn riskless profit and construct a table showing the cashflows at initiation and expiration to demonstrate that your strategy is correct. Note part 4b) is independent of part 4c).               (5 marks)

d) Now, you wish to connect the Binomial model to the continuous-time equivalent provided by the Black-Scholes-Merton model. The continuously compounded equivalent of 2.5628% is 2.5305%. Calculate the theoretical option price of December European call and put using the BSM model. Show the formulas and calculations.       (5 marks)

e) Compare the theoretical option price of European call and put obtained from the two pricing models in Task (4a) and (4d). What do you notice? Discuss the relative strengths and weaknesses of the Black-Scholes-Merton and Binomial option pricing models.     (8 marks)

Task 5: Report Overall Quality and Written Expression (4 marks)

The overall report quality will be marked based on the organization, presentation, writing, referencing, and the ability to effectively exchange information and ideas through the written word. Essential contents in your report:

• Page numbering

• Sections numbering

• Executive summary

• Table of contents

• Reference list

ASSIGNMENT GUIDELINE

Due date: Friday, 7th October 2022, 5 pm Melbourne time (Week 11). A late penalty will apply for late submissions where special consideration has not been granted.

Weight: 40%

General requirements

1.   Students are required to work in groups of no more than three students.

2.   Students should not expect the lecturer to provide direct assistance on any questions. Any questions of a general nature should be posted on the discussion board rather than emailed to the lecturer so that the response is available for all students to see.

3.   Once the group is registered, the group members will not be allowed to switch to another group.

4.   It is expected that each student contributes actively to the group work until it is completed.

5.   The  group  assignment  should  not  exceed  3,500  words  (show  the  word  count  on  the assignment's first page).

6.   The marking rubric for the assignment is provided on the last four pages.

7.   Assignments are to be prepared in MS Word and submitted in PDF on the Canvas. Submit the PDF document only – separate MS Word or EXCEL files are not acceptable and will not be marked.

8.   Remember to show all working/detailed steps (e.g. formulae) that lead to the final answers. The accuracy of numerical results (due to rounding off) is not a significant issue.

Submission Instructions

1.   Only one Electronic copy of the Group Assignment is to be submitted per group.

2.   Ensure to attach the RMIT's Assignment Cover Sheet (with all details filled) to the front page of your submitted document. The Cover Sheet can be found on Canvas – Assignment tab => Assessment Task 2: Group Assignment

3.   An assignment is to be prepared in MS Word and submitted in PDF form on Canvas in the name with the following format: BAFI2081_PG_X.pdf. (eg. BAFI2081_PG_ 1.pdf)

X stands for your assigned group number, which can be found on Canvas under the People Tab => Project Group.

4.   Upload  the  PDF  file  to  the  Turnitin/Canvas  submission  link  under  Assignment  tab  => Assessment Task 2: Group Assignment => Submit Assignment before the deadline.

Late Submissions

All assignments will be marked as if submitted on time. Late submissions of assignments without special consideration or extension will be automatically penalized at a rate of 10% of the total marks available per day (or part of a day) late.

Assessment Feedback

You will normally receive marks and feedback on in-course assessment tasks within ten working days of the deadline for submitting that work, or, where an extension has been granted, within ten working days of the agreed extended due date.