# FNCE30007 Derivative Securities Unimelb Assignment Answer

This is the Assignment Sample of FNCE30007 Derivative Securities Unimelb.

This subject focuses on the application and valuation of derivative securities, such as forwards, futures, swaps, and options.

The focus will be on how to trade using both derivatives and cash rates so that people can trade in different markets. It will also look at hedging strategies to help people borrow money from banks.

You can use a forward market to hedge against fluctuations in interest rates. The foreign exchange market is used for trading futures contracts, which are traded at exchanges around the world.

You’ll learn how these tools work. You’ll learn about how they worked in early World War II when countries had to borrow money from other places, but could not trade with other countries because of war restrictions.

You’ll also learn a lot about the pricing of certain securities that you can read about in your own time through any number of finance textbooks.

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## Assignment Solution Of FNCE30007 Derivative Securities Unimelb

### Assignment Task 1. Explain the role of derivatives exchanges and the characteristics of derivative securities.

Derivative exchanges buy and sell derivative securities. One characteristic of a derivative financial instrument is that it has no intrinsic value; rather, its price reflects changes in the underlying asset price.

For example, if a stock’s current share value is $120 and someone buys call (right) options for it with an exercise price (strike) of $150 then they have control over 100 shares at a purchase cost of only $6,000.

The more the stock goes up or down, the higher their potential profit grows – assuming they use the option before it expires.

If they don’t use it before the option expires then their ownership of 100 shares at $150 will cost them only $6,000.

The most common derivative securities are futures, forwards, and options; these are traded on major exchanges where the terms surrounding transaction prices and volumes are made public. The value of derivative security is derived from an underlying asset.

### Assignment Task 2. Explain the role of arbitrage as a basis for determining the prices of derivative securities.

The role of arbitrage in the prices of derivatives securities is based on the idea that a security’s price should not vary substantially between brokers.

The theory here is essentially identical to the principle used to determine the “fair” price for commodities, except it relies heavily on computers that work tirelessly and 24/7 to execute trades with little market impact.

Therefore, noise traders who are trying to set prices by buying and selling are outbid by people with either more accurate orders or who are making bets on a change in the data.

To use me as an example, I have been investing my personal funds in equity derivatives (futures contracts bought through a broker) for 10+ years;

I have a proven track record of making consistently accurate predictions about changes in fundamental variables, and so my trades are high-priority.

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### Assignment Activity 3. Explain the mechanics of trading futures contracts, forward contracts, and options.

Trading futures contracts, forward contracts, and options all involve the implementation of some kind of financial agreement between two parties.

A futures contract is an agreement with a delivery date or duration in which one party agrees to deliver a specific asset at an agreed-upon price on the given date.

Forward contracting is a type of contract in which you agree to something on a future date. But there’s no set price point.

It usually trades across borders because they need this type of contract for international trade.

The downside is that it can be hard to enforce because the goods are not delivered until they have been delivered and so you cannot track them.

Also, options trading only gives people the right, but not the obligation to buy an asset at a given and specific price on a given date.

### Assignment Activity 4. Design and manipulate payoff diagrams for various derivative securities;

The payoff diagram is the plot of the payoff values against time with each point representing a certain future date.

A graph of this kind describes the cash flow between us and our counterparty as it can change over time, and helps us to assess how our investment might behave in different market scenarios.

This is what we want. We want areas above the line that give us positive returns, and areas below the line that give us negative returns. If it falls in-between, then it is called an asymmetric pay-off or a skewed pay-off.

For instance, using a simple payoff diagram we can see that buying an asset without any consideration of time is one example of this.

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### Assignment Task 5. Calculate option prices using the Black-Scholes and binomial models.

There are many ways to calculate options prices, one of the most popular methods-also known as the Black-Scholes model–requires knowing volatility and its assumed constant volatility, time to expiration, and expected stock price.

Assuming that price follows geometric Brownian motion with constant variance (called Efficient Market Hypothesis), we can use the formula BM=(Ps^(rt)*sqrt((r-delta)T*sigma*v^2))/v.

The formula for Ps is current stock price and r is the interest rate per annum for continuous compounding (e.g., 8% = 0.08). The t equals the number of years until expiration.

Sigma equals volatility of underlying assets over a period of time (volatility of the underlying assets per unit time). Delta equals the risk-free rate of return, and v equals expected volatility.

The required values are Ps, r, sigma, t, and v. From historical data on stock prices and volatility, we can find Ps (price) and v (volatility). The risk-free discount rate can be found from a bond with an effective maturity that matches the option’s time to expiration.

The volatility of the stock can be measured by looking at historical data on past returns or estimated using a number of different techniques. We’ll look at two of them here:

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### Assignment Activity 6. Explain how derivative securities can be used in hedging.

Derivative securities can be used in hedging because they enable a company to protect its income stream from the volatile changes that often occur in foreign currency rates.

Derivatives can also be used by investors who are looking for insurance for their investments and want to minimize the risks of short-term fluctuations. Derivatives are useful because they can help companies and investors save money.

The company saves money because it is protected from fluctuations in the market, and the investor saves money because he or she doesn’t need a lot of capital to buy things like stocks.

Derivatives also make it so people who don’t have enough money to buy something but want to still be able to have an investment can use derivatives instead.

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