1. Design New Options and 2. Arbitrage

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Question #1 [Derivatives Markets and Financial Innovations]
Prepare a 6-page minimum (11?2-spaced paragraphs) report on your own original research of Derivatives Markets and Financial Innovations, by completing ALL of the following steps and answering ALL of the following questions:
Derivatives Markets and Financial Innovations Provide an original proposal for new derivative product(s) and innovations: What new derivative product(s) would you consider introducing to the derivatives markets? Provide your original example with detailed and specific descriptions of your proposed new derivative product(s). Your proposal of new derivative product(s) should include the following steps with your original discussions and your own analyses:
Step (1) Derivatives Markets and Financial Innovations: Discuss the essence and primary purposes of the derivatives markets as the background of your proposed derivatives and financial innovations. Provide your original and detailed discussions to the followings: What new derivative product(s) would you consider introducing to the derivatives markets? What are the most important aspects of the design of a new derivative contract? Discuss the major reasons, motivations and needs for introducing the proposed new derivative product(s) and financial innovations.
Important Instructions: Provide your answers to the above questions with your own insights, examples and applications of derivatives theories and concepts. Your proposed new derivative product(s) should be original and based on your own ideas and insights. To answer the above questions, you need to provide your own discussions of derivatives, such as the objectives, uses/applications of derivatives and derivatives markets. Your answers should highlight the important aspects of the design of a new derivative contract. Please explain your answers with references to examples and data. To begin you research, visit the following URL link for background information about CBOE’s exiting products: https://www.cboe.com/Products/default.aspx
Step (2) Underlying Assets: Provide detailed discussions and explicit analyses of the underlying asset and risk driver of your proposed derivative product(s). For example, discuss the spot market of the underlying asset (if any), whether the underlying asset is tradeable or non-tradeable, and the economic characteristics (such as price, volatility, uncertainty, etc.) of the underlying asset, etc. Importantly, use real data and estimate volatility (?) of the underlying asset of the proposed derivative.
Important Instructions: Provide data and summary statistics to support your discussions and quantitative analyses of the underlying asset (or risk driver) of your proposed derivative
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product(s). Importantly, provide data of price and estimate volatility of returns (or other important statistics) of the underlying asset. The estimated volatility will be useful information to understand the uncertainty (volatility) of the underlying asset of the proposed derivative product(s); it will also be used as an important input variable to compute option pricing models (see Step (5) below).
Step (3) Design of Proposed Derivative Product: Provide detailed discussions of the design and product specifications of your proposed derivative contract(s). Discuss the key assumptions and features of your proposed derivative product(s). Note that your proposed derivative product should include option contract so that you can perform option pricing models in Step (5) below.
Important Instructions: Provide explicit discussions of all of the specifications your proposed derivatives product(s), such as: price, quantity, unit of underlying asset, maturity date, delivery policy (if any), exercising policy (if options), long/short positions, margin requirement and daily settlement (if any), transaction costs, among others. You should use data and numerical examples to support your assumptions and specifications of proposed derivative product(s).
Step (4) Proposed Derivatives Markets: Discuss the derivatives markets of your proposed derivative product(s). Discuss the major types of investors/traders who will be trading the proposed derivative products, and explain why these investors/traders will be interested in trading your proposed derivatives and benefit from your proposed financial innovations. Also, discuss why your proposed new derivative products satisfy the 3 Zs (Zero-Initial Value, Zero-Net Supply, and Zero- Sum Game) of derivatives.
Important Instructions: Provide explicit discussions of the major types of investors/traders who will be trading the proposed derivatives product, e.g. hedgers, speculators, arbitrageurs, market makers, etc. Use data and numerical examples to support your qualitative discussions.
Step (5) Derivative Pricing Models [IMPORTANT]: Create quantitative derivative pricing and valuation models of your proposed derivative product note that this step is very important; theoretical models, quantitative analyses and numerical examples should be provided in this step. Propose and demonstrate quantitative models to price and value your proposed derivatives. Equally important, demonstrate how your proposed derivatives can be priced and hedged using option pricing models. For Step (5), complete all of the following steps:
(a) Apply option pricing models for your proposed derivative product(s). You should provide detailed and clear discussions on the major parameters of the models, including the following
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variables (note that your proposed derivative product(s) may vary, and may include additional variables):
? (i) Type(s) of the derivative contract;
? (ii) Underlying asset/risk driver;
? (iii) Exercise/delivery price;
? (iv) Volatility (?) an important variable for options; please provide detailed
analyses on how you estimate the volatility as in Step (2) above;
? (v) Maturity and exercise/delivery policy;
? (vi) Required risk-free rate of return (you may assume risk-free rate of 3-4%).
Importantly, provide detailed and clear explanations of your derivative assumptions and parameters.
(b) Construct quantitative option pricing models that can be used for valuation and pricing of your proposed derivative. You may consider the following option pricing models: Binomial Option Pricing Model, Black-Scholes-Merton Model, and/or any other relevant option pricing models (e.g. multi-step binomial model, trinomial model, stochastic volatility model, jump diffusion model, etc.). Provide numerical examples (e.g. assigning numerical values of your assumptions) to demonstrate the pricing of your proposed derivative(s).
(c) [IMPORTANT] Provide Sensitivity Analyses to demonstrate how the pricing/valuation of your proposed derivative changes with alternative values/parameters of assumptions used in (b) above. For example, you can perform sensitivity analyses using different values of volatility assumption (for examining Vega), other inputs for option pricing models, etc.
(d) Discuss how to the proposed derivative product can be hedged and constructed/replicated by the sellers (or market makers). Note: this step is important to explain why your proposed derivative product can be priced using the principle of Risk Neutral Valuation.
Step (6) Policy Recommendations: Discuss the main reasons why your proposed new derivative product(s) and financial innovations will be successful and sustainable. If you are the policy maker or regulator of the proposed derivatives market, what policies and regulatory features you would propose to enable the well-functioning, efficiency, and sustainability of derivatives markets? What factors should be considered by policy maker when introducing a new derivatives contract to the markets? Provide your own policy recommendations on the key ingredients (including important conditions of derivative market functions and regulations) that will contribute to the success of your proposed new derivative market. Important Instructions: Apply different theories and concepts learned from this class to address important conditions of functions and regulations of your proposed derivative market.
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Hint: see Class #2; important ingredients of the successful derivatives functions and regulations may include the followings: standardization, competitive markets, liquidity, price discovery, transparency, volatility, mitigation of default risk, transaction costs, among others.
Step (7) Conclusion: Provide a concluding section that summarize your new insights, original findings, and learning outcomes of this project. In concluding section, please summarize:
(i) the key findings and contributions of your research; and
(ii) the key lessons and learning outcomes of this project, including the new ideas, concepts, and implications you have learnt from this project.
? Learning Outcomes: Understanding of fundamental concepts of derivatives markets and applications of financial theories. Learning of research, analytical, and statistical/empirical skills for derivatives research and policy analyses. Applications of theories and analytical frameworks in understanding the modern issues of derivatives markets. Learning of research, analytical, and statistical/empirical skills for derivatives research and policy analyses. Developing strategic insights and creative solutions to derivatives markets.
Important Instructions and Evaluation Criteria:
All analyses and discussions must be original, rigorous, well-organized, concise, and integrated with frameworks and tables/figures of numerical results. Explain and present all your assumptions, calculations, and ideas as clear as possible. Summary tables/figures of numerical results should be provided to support your original analyses and findings.
Your individual research will be critically evaluated based on the following criteria: (I) the rigor and completeness of your research and analyses, including the quantitative analyses, derivative pricing models and sensitivity analyses; (II) the theoretical applications, original insights and quality of your individual research; and (III) your learning outcomes and demonstrations of successful applications of derivatives theories, concepts, and techniques.
Please make sure that you provide citations and complete references of any sources of research, information and data used in your report; e.g. provide reference of information from different sources of research (such as CBOE, CBOT, Wall Street Journal, etc.). Make sure you provide explicit references and tables of numerical results or summary statistics to support your research and original findings. Your report should also include an Appendix that contains any additional information used in your analyses.5
Question #2 [Arbitrage Strategies]
Prepare a 11?2-page minimum (11?2-spaced paragraphs) report of your original insights of Arbitrage, and an original application of Arbitrage Strategy.
Step (1) Based on your own insights, discuss the concept of Arbitrage and provide an original application of Arbitrage Strategy in the derivatives and financial markets. Propose, construct and analyze an original example of Arbitrage Strategy, which you think may exist in the derivatives and financial markets.
Step (2) Demonstrate and explain why your proposed arbitrage strategy in the financial markets can generate abnormal returns/profits and whether the arbitrage profits can be sustained over time. Be specific, rigorous and creative.
Step (3) [IMPORTANT] Provide (a) theoretical models and (b) quantitative analyses with real data and numerical examples to demonstrate your proposed Arbitrage Strategy. Provide summary tables of quantitative analyses and numerical results, and show the steps and outcomes of your proposed arbitrage.
Step (4) In concluding section, please summarize: (i) your key findings, and (ii) your key lessons and learning outcomes (including new ideas, concepts, and implications) of this project. ? Learning Outcomes: Applications of the concepts of Arbitrage and derivatives
markets. Developing original insights and creative ideas of arbitrage strategies and derivatives. Learning of research, analytical, and quantitative skills.
Important Instructions and Suggestions:
All analyses and discussions must be original, rigorous, well-organized, concise, and integrated with frameworks and tables/figures of numerical results. Explain and present all your assumptions, calculations, and ideas as clear as possible.
Your individual research will be critically evaluated based on the following criteria: (I) the rigor and completeness of your research and analyses, including the quantitative analyses, derivative pricing models and sensitivity analyses; (II) the theoretical applications, original insights and quality of your individual research; and (III) your learning outcomes and demonstrations of successful applications of derivatives theories, concepts, and techniques.
If you use information and data from different research and resources (such as Wall Street Journal, CBOE, financial materials/databases, etc.) to support your original analyses/discussions of arbitrage strategy, please make sure that you provide citations and references of the sources of the information and data. Make sure you provide explicit references and tables of numerical results or summary statistics to support your research and original findings. Your report should also include an Appendix that contains any additional information used in your analyses.
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