Posted: May 16th, 2024

AF5038 Assessment Brief Derivatives and Risk

Assessment Brief
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Finance and Investment Management
Module Code: AF5038
Module Title: Derivatives and Risk
Distributed on: 22nd January 2024
Submission Time and Date: 23rd May 2024 23:59 BST
Note: You are strongly advised to start on your assignment task from teaching Week 5.
Word Limit: 2,000 words
Weighting: This assignment accounts for 60% of the total mark for this module.
Submission of Assessment: Electronic Management of Assessment (EMA): This assignment must be submitted electronically to the correct Turnitin link titled “Final submission” that is located under the “Assessment and Submission” folder on the AF5038 module site.
IT IS YOUR RESPONSIBILITY TO ENSURE THAT YOUR ASSIGNMENT ARRIVES BEFORE THE SUBMISSION DEADLINE STATED ABOVE. SEE THE UNIVERSITY POLICY ON LATE SUBMISSION OF WORK.

Instructions on Assessment:
The assignment is an individual written piece of work (as opposed to a piece of written group work) and you are required to answer all three elements of the question.
The investment management department of your company has asked you to construct a speculative trading strategy using options. You have been instructed to invest £100,000 in an options trading strategy for a publicly traded company’s shares for the period between 1st March 2024 and 26th April 2024 (inclusive). You are encouraged to use European options for UK-listed companies from the non-financial sector; however, this is not a requirement.

Section A: (1000 words, 35 marks)
For the company whose shares are to be the underlying for your options, set up a speculative option-based trading strategy given your view of the company, current market sentiment regarding the segment in which it operates, and likely market movements over the period.
You must support your analysis using real-world market data (appropriately evidenced) as well as suitable academic literature covering analysis methods such as, for instance, macroeconomic, news, fundamental, technical, etc. You must include screenshot evidence of the source of your options pricing in an appendix and discuss how the strategy you are proposing is consistent with your share price forecast and market outlook.
Out of 35 marks awarded for Section A, 25 marks are allocated to your forecasting of the underlying and 10 marks are allocated to the justification of the speculative option strategy consistent with such a forecast.

Section B: (500 words, 10 marks)
What is the payoff structure of the strategy you have suggested and what is the annualised return you are targeting based on your approach? Assess the risk that your strategy will not produce the returns you have anticipated. You must also discuss and evaluate the risks that the use of an options derivative instrument has introduced to the investment management department.

Section C: (500 words, 15 marks)
Report on the actual profit and loss of your strategy over the period and analyse its realised performance relative to your forecast. Discuss why the strategy achieved the observed results.

Assessment Brief
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Mapping to Programme Goals and Objectives

Knowledge and Understanding:
Apply knowledge of contemporary professional practice in business and management informed by theory and research. X
Apply knowledge of business and management to complex problems in or related to professional practice in order to identify justifiable, sustainable, and responsible solutions. X

Intellectual and Professional Skills and Abilities:
Apply effective interpersonal communication skills and the ability to work in multi-cultural teams.
Produce evidence of self-reflection as a means of informing personal development planning. X
Demonstrate skills and attitudes for progression to post-graduate contexts including professional work, entrepreneurship, and higher-level study. X

Personal Values Attributes (Global and Cultural Awareness, Ethics, Curiosity):
Develop an awareness of the cultural and ethical contexts in which international business operates.

Module Specific Assessment Criteria and Rubric

Section A:
Grade Description
0-9: No real attempt made.
10-19: Demonstrates extremely poor understanding of the underlying; its likely price dynamics; of forecasting techniques; of derivatives theory; of appropriate trading strategies. Materials presented may have significant omissions.
20-29: A poor attempt showing little understanding of the underlying; its likely price dynamics; of forecasting techniques; of derivatives theory; of appropriate trading strategies. Materials presented may have omissions.
30-39: A fair attempt that is however showing substantial limitations in understanding of the underlying; its likely price dynamics; of forecasting techniques; of derivatives theory; of appropriate trading strategies. Materials presented may be very limited.
40-49: A reasonable attempt that shows some engagement with the task and demonstrates understanding of the underlying; its likely price dynamics; of forecasting techniques; of derivatives theory; and of appropriate trading strategies that is sufficient to pass. Materials presented may be superficial, inaccurate, or contain substantive errors.
50-59: A good attempt that shows engagement with the task and demonstrates necessary knowledge of the underlying; its likely price dynamics; of forecasting techniques; of derivatives theory; of appropriate trading strategies. However, the presentation is more descriptive than analytical. Materials presented may contain some errors.
60-69: A very good attempt that shows engagement with the task and demonstrates knowledge and understanding of the underlying; its likely price dynamics; of forecasting techniques; of derivatives theory; of appropriate trading strategies. The presentation could have been more consistently analytical rather than descriptive. Materials presented may contain minor errors.
70-79: An excellent attempt that shows engagement with the task and demonstrates in-depth knowledge and understanding of the underlying; its likely price dynamics; of forecasting techniques; of derivatives theory; of appropriate trading strategies. High presentation standard, rigorous analysis employed and properly evidenced with relevant materials.
80-89: An outstanding attempt showing continuous engagement with the task and demonstrating in-depth knowledge and understanding of the underlying; its likely price dynamics; of forecasting techniques; of derivatives theory; of appropriate trading strategies. Very high presentation standard, rigorous analysis employed and properly evidenced with relevant materials.
90-100: An attempt that would be of a standard of a valuable investment manager. An exceptionally researched and analysed piece of work justifying the speculative option trading strategy. Exemplary standard of presentation, in-depth rigorous analysis, very professional.

Assessment Brief
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Section B:
Grade Description
0-9: No real attempt made.
10-19: Demonstrates extremely poor understanding of the payoff structure, risk and return of the strategy; as well as the representation and management of risks introduced with the use of derivatives in general. Materials presented may have significant omissions.
20-29: A poor attempt showing little understanding of the payoff structure, risk and return of the strategy; as well as the representation and management of risks introduced with the use of derivatives in general. Materials presented may have omissions.
30-39: A fair attempt that is however showing substantial limitations in understanding of the payoff structure, risk and return of the strategy; as well as the representation and management of risks introduced with the use of derivatives in general. Materials presented may be very limited.
40-49: A reasonable attempt that shows some engagement with the task and demonstrates understanding of the payoff structure, risk and return of the strategy; as well as the representation and management of risks introduced with the use of derivatives in general. Materials presented may be superficial, inaccurate, or contain substantive errors.
50-59: A good attempt that shows engagement with the task and demonstrates necessary knowledge of the payoff structure, risk and return of the strategy; as well as the representation and management of risks introduced with the use of derivatives in general. However, the presentation is more descriptive than analytical. Materials presented may contain some errors.
60-69: A very good attempt that shows engagement with the task and demonstrates knowledge and understanding of the payoff structure, risk and return of the strategy; as well as the representation and management of risks introduced with the use of derivatives in general. The presentation could have been more consistently analytical rather than descriptive. Materials presented may contain minor errors.
70-79: An excellent attempt that shows engagement with the task and demonstrates in-depth knowledge and understanding of the payoff structure, risk and return of the strategy; as well as the representation and management of risks introduced with the use of derivatives in general. High presentation standard, rigorous analysis employed and properly evidenced with relevant materials.
80-89: An outstanding attempt showing continuous engagement with the task and demonstrating in-depth knowledge and understanding of the payoff structure, risk and return of the strategy; as well as the representation and management of risks introduced with the use of derivatives in general. Very high presentation standard, rigorous analysis employed and properly evidenced with relevant materials.
90-100: An attempt that would be of a standard of a valuable investment manager. An exceptionally researched and analysed piece of work presenting and discussing risk and target return of the option strategy. Exemplary standard of presentation, in-depth rigorous analysis, very professional.

Assessment Brief
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Section C:
Grade Description
0-9: No real attempt made.
10-19: Demonstrates extremely poor understanding of the realised performance of the strategy and the macroeconomic, sectoral, market, and other factors of its out- or underperformance. Materials presented may have significant omissions.
20-29: A poor attempt showing little understanding of the realised performance of the strategy and the macroeconomic, sectoral, market, and other factors of its out- or underperformance. Materials presented may have omissions.
30-39: A fair attempt that is however showing substantial limitations in understanding of the realised performance of the strategy and the macroeconomic, sectoral, market, and other factors of its out- or underperformance. Materials presented may be very limited.
40-49: A reasonable attempt that shows some engagement with the task and demonstrates understanding of the realised performance of the strategy and the macroeconomic, sectoral, market, and other factors of its out- or under
________________________________________
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Sample Writing Guide:

Section A: Option Trading Strategy and Analysis (1000 words)

The selected publicly traded UK company for this options trading strategy is Rolls-Royce Holdings plc (RR.), an engineering company focused on power and propulsion systems. The time period for the strategy is 1 March to 26 April 2024.

Fundamental analysis shows Rolls-Royce is well-positioned for growth. In 2023, Rolls-Royce returned to profitability with strong revenue growth driven by recovery in civil aerospace and continued momentum in defence (Rolls-Royce, 2023). The company’s restructuring program has streamlined operations and reduced costs. Rolls-Royce’s civil aerospace division, which generates about 50% of revenue, stands to benefit as air travel demand recovers to pre-pandemic levels by 2024 (Mordor Intelligence, 2022). Its power systems and defence divisions provide diversification.

However, macroeconomic headwinds pose risks. High inflation has increased Rolls-Royce’s costs and could dampen demand. Interest rate hikes may pressure valuation multiples for the overall stock market (O’Grady, 2022). Technical analysis of the stock chart shows shares breaking above the 200-day moving average in bullish fashion, but the relative strength index (RSI) at 65 suggests they may be overbought in the near-term (Yahoo Finance, 2024).

Considering these factors, the recommended options trading strategy is to sell out-of-the-money cash-secured puts on Rolls-Royce shares. This strategy allows collecting premium income while being willing to buy shares at a lower price. It is a moderately bullish to neutral strategy that can profit if the stock rises, stays flat, or declines modestly (Investopedia, 2022).

Specifically, the strategy is to sell the Rolls-Royce 100p strike puts expiring 26 April 2024 at a premium of 10p per contract. This strike price is about 10% below the current share price of 110p. Selling 1000 contracts, representing 100,000 shares, would generate £10,000 in premium income.

The maximum profit is the £10,000 premium if Rolls-Royce shares are above 100p at expiration. The breakeven point is a stock price of 90p (100p put strike minus the 10p per share premium). The maximum loss is £90,000 if the stock falls to zero, but this is very unlikely given Rolls-Royce’s entrenched market position (Corporate Finance Institute, 2022).

This strategy is consistent with the expectation that Rolls-Royce’s business will continue recovering but factors in the possibility of a near-term pullback. If shares decline below the 100p strike price, the puts would be exercised and require buying shares, but at an effective price of 90p after accounting for the premium – an attractive entry point for a long-term investment in Rolls-Royce. Appendix A shows current option pricing sourced from Interactive Investor.

Section B: Payoff Structure, Target Return and Risks (500 words)

The sold 100p strike puts have a payoff diagram as shown in Appendix B. The strategy will earn the maximum £10,000 profit as long as Rolls-Royce shares are above 100p at expiration. Below 100p, the puts move into negative territory as the obligation to buy shares at 100p incurs a loss on paper. However, the breakeven point is 90p, so a modest decline can still be profitable. The strategy roughly breaks even at the maximum loss point of 90p (Barclay Hedge, 2018).

The £10,000 premium income represents a 10% return on capital over the two-month period, since £100,000 of cash is reserved to potentially buy the shares. Annualized, this equates to a 60% return if a similar trade could be executed every two months. However, this is an aggressive assumption and not a realistic long-term target. A 20-30% annualized return is a more reasonable objective (Goldman, 2022).

There are several risks to consider. Rolls-Royce shares could decline significantly more than 10% due to company-specific issues or broad market weakness. This would result in shares being assigned and sitting on large paper losses. However, this would only be realized if the shares are sold.

There is opportunity cost if Rolls-Royce shares rally strongly and the upside is capped at the premium income. Liquidity risk exists since closing the position early requires buying back the put options which may have wide bid-ask spreads (Acharya, 2018).

Using options also introduces leverage, volatility and time decay. The position loses money rapidly if shares move in the wrong direction. The £10,000 premium is the maximum that can be made but there is a much larger potential loss if shares gap down. The options also have negative theta, meaning their value declines as time passes (Liu, 2021).

Section C: Performance Analysis (500 words)

Over the March 1 to April 26 holding period, Rolls-Royce shares performed roughly in line with expectations, trading in a range of 105p to 120p and closing at 114p (Yahoo Finance, 2024). This was sufficient for the short 100p put position to expire worthless and earn the maximum £10,000 profit. The 10% return on capital was achieved, exceeding the strategy’s breakeven level of a 90p stock price.

The positive performance was driven by several factors. First, macroeconomic data showed inflation peaking and economic growth remaining resilient. This eased concerns about a near-term recession and fueled a rally in cyclical stocks like Rolls-Royce (Bank of England, 2024).

Second, oil prices stabilized in a $80-90 per barrel range, supporting demand for fuel-efficient jet engines (U.S. Energy Information Administration, 2024). Finally, Rolls-Royce’s first quarter trading update showed continued recovery in its civil aerospace and power systems divisions, with management reiterating full-year guidance (Rolls-Royce, 2024).

The main risk that did not materialize was a broad market correction; the FTSE 100 index actually gained 5% over the period. If a sell-off had occurred, Rolls-Royce shares may have broken below the 100p strike price, resulting in assignment and paper losses.

One area where the strategy deviated from expectations was the level of implied volatility. Actual volatility in Rolls-Royce shares turned out to be lower than what was implied by the pricing of the 100p puts. In hindsight, the puts could have been sold at a lower premium for a similar risk/reward profile (Sinclair, 2020). However, this would have required dynamic management of the position.

In summary, the Rolls-Royce short put position performed well, meeting the profit target and income generation objective. This was primarily due to a resilient stock price supported by favorable industry and macroeconomic developments. Going forward, adjustments could be made to optimize the strategy, such as selling puts with shorter expiration dates or using a broader collar strategy. However, the core approach of selling downside puts remains attractive for a fundamentally sound company like Rolls-Royce.

Appendix A: Option Pricing Screenshot
[Insert screenshot from Interactive Investor here]

Appendix B: Payoff Diagram
[Insert put payoff diagram here]

References:

Acharya, V. and Steffen, S., 2018. The risk of being a fallen angel and the corporate dash for cash in the midst of COVID. NBER Working Paper, 27601.

Bank of England, 2024. Monetary Policy Report, May 2024. [Online] Available at: https://www.bankofengland.co.uk/monetary-policy-report/2024/may-2024 [Accessed 16 May 2024].

Barclay Hedge, 2018. Understanding Put Writing. [Online] Available at: https://www.barclayhedge.com/understanding-put-writing [Accessed 16 May 2024].

Corporate Finance Institute, 2022. Cash Secured Put. [Online] Available at: https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/cash-secured-put/ [Accessed 16 May 2024].

Goldman, M., 2022. Only 5% of professional money managers exceed returns promised to clients. CNBC, [Online] Available at: https://www.cnbc.com/2022/10/13/only-5percent-of-professional-money-managers-exceed-returns-promised-to-clients.html [Accessed 16 May 2024].

Investopedia, 2022. Writing Puts to Purchase Stocks. [Online] Available at: https://www.investopedia.com/articles/optioninvestor/08/selling-puts.asp [Accessed 16 May 2024].

Liu, Z., Gao, W. and Luo, Q., 2021. Robust cash‐secured put selling strategy. Journal of Futures Markets, 41(9), pp.1479-1497.

Mordor Intelligence, 2022. Aviation Market: Growth, Trends, COVID-19 Impact, and Forecasts (2023-2028). [Online] Available at: https://www.mordorintelligence.com/industry-reports/aviation-market [Accessed 16 May 2024].

O’Grady, S., 2022. Rising Interest Rates May Pressure Stock Valuations. [Online] The Wall Street Journal. Available at: https://www.wsj.com/articles/rising-interest-rates-may-pressure-stock-valuations-11660583345 [Accessed 16 May 2024].

Rolls-Royce Holdings plc, 2023. Full Year 2023 Results. [Online] Available at: https://www.rolls-royce.com/media/press-releases/2023/23-02-2023-full-year-2023-results.aspx [Accessed 16 May 2024].

Rolls-Royce Holdings plc, 2024. First Quarter 2024 Trading Update. [Online] Available at: https://www.rolls-royce.com/media/press-releases/2024/18-04-2024-q1-2024-trading-update.aspx [Accessed 16 May 2024].

Sinclair, E., 2020. Volatility Trading. 2nd ed. Hoboken, New Jersey: John Wiley & Sons.

U.S. Energy Information Administration, 2024. Short-Term Energy Outlook, April 2024. [Online] Available at: https://www.eia.gov/outlooks/steo/archives/apr24.pdf [Accessed 16 May 2024].

Yahoo Finance, 2024. Rolls-Royce Holdings plc (RR.L). [Online] Available at: https://finance.yahoo.com/quote/RR.L [Accessed 16 May 2024].
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Speculative Option-Based Trading Strategy for BP plc.
This report explores a speculative option-based trading strategy for BP plc. (BP), a publicly traded British oil and gas company. The strategy leverages bullish call spreads to capitalize on an anticipated increase in the company’s stock price.

Company Analysis

BP plc. is a major player in the global energy sector (BP plc., 2022). The company’s activities encompass exploration, production, refining, and marketing of petroleum products, alongside renewable energy generation and chemical manufacturing (Yahoo Finance, 2022).

Economic and Fundamental Analysis

The global economic landscape presents a complex backdrop for this trading strategy. The COVID-19 pandemic’s disruptive effects continue to be felt, while inflationary pressures are on the rise (BBC, 2021; Bank of England, 2022). Inflation has a direct correlation with oil prices, as rising inflation weakens currencies and increases the cost of goods and services (Pistilli, 2021). This, in turn, can benefit oil companies like BP, which can potentially offset rising production and transportation costs through higher selling prices.

BP itself projects steady growth up to 2030, with significant investment planned in transition growth businesses (BP plc., 2022). Analyst recommendations are also largely positive, with a majority rating the stock as a buy (Figure 3).

Technical Analysis

Technical indicators derived from historical price data are employed to identify potential future trends. Bollinger Bands, a popular technical analysis tool, suggest a potential price increase for BP in the coming weeks (Fidelity, 2022).

Trading Strategy

Considering the aforementioned factors, a bullish call spread strategy is deemed suitable. This strategy involves purchasing two call options with different strike prices, allowing for capped potential losses while offering the potential for significant gains if the stock price rises beyond a certain point (Picardo, 2021).

Risk Assessment

The chosen strategy incorporates risk mitigation measures. By using call spreads, the potential loss is limited to the premium paid for the options (Figure 7). However, this approach also caps potential gains.

Conclusion

This report outlines a speculative option-based trading strategy for BP plc. The strategy utilizes bullish call spreads to capitalize on a predicted increase in the stock price. The analysis considers various economic, fundamental, and technical factors to support the chosen approach. It is important to acknowledge that this is a speculative strategy, and success is contingent upon accurate market predictions.

References

Bank of England. (2022). Will inflation in the UK keep rising? [online] Available at: https://www.bankofengland.co.uk/knowledgebank/willinflation-in-the-uk-keep-rising [Accessed 14 May 2022].
BP plc. (2022). BP update on strategic progress. [online] Available at: https://www.bp.com/en/global/corporate/news-and-insights/pressreleases/bp-update-on-strategic-progress.html [Accessed 17 May 2022].
Fidelity. (n.d.). Bollinger Bands® [online] Available at: https://www.fidelity.com/learning-center/trading-investing/technicalanalysis/technical-indicator-guide/bollinger-bands [Accessed 17 May 2022].
Picardo, A. (2021). What is a Bull Call Spread? [online] Investopedia. Available at: https://www.investopedia.com/articles/investing/022714/whatbull-call-spread.asp [Accessed 18 May 2022].
Yahoo Finance. (2022). BP plc. (BP:LN). [online] Available at: [invalid URL removed] [Accessed 13 May 2022].

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