Part A: Options Mispricing and Arbitrage
Identify a mispriced option and execute an arbitrage strategy for the relevant period (detailed further below). Your report must include the following:
a. Calculate the theoretical fair value of the available put and call options using the Black Scholes Model. State and justify all inputs and assumptions and show your workings.
(3 marks)
b. Based on your findings above, compare your theoretical fair value to current market prices on 30th January and identify which option (if any) is mispriced. Provide your rationale as to why.
(2 marks)
c. Demonstrate two ways you could exploit arbitrage opportunities (highlighted in part (i) and (ii) below. In doing so, document the details of the relevant transactions at the beginning and end of the relevant period and explain how the arbitrage strategy will work. Include transaction costs and cost of capital considerations in your calculations.
(i) A synthetic arbitrage strategy to generate profit on the 3e January
(3 marks)
(ii) A delta neutral arbitrage from 30th January to 3rd February. No rebalancing is required
due to the short time horizon (assume 100 option contracts are executed)
(3 marks)
d. Evaluate the performance of your strategies by working out the profit or loss, the percentage return and comparison to a relevant benchmark, as well as reflecting on potential sources of ineffectiveness (e.g., imperfections in the strategy and/or why is worked well or didn’t work well)
(3 marks)
Part B: Options Strategy
Determine an appropriate option strategy to trade in the prevailing market conditions, defined as the period 30′ January to 18th May 2023 (Expiry) (“the relevant period’). Your report must:
Document your objective, outline your option strategy and its appropriateness to achieve your objective (create your own objective/narrative) (3 marks)
Show all transactions pertaining to the execution of your strategy for the relevant period (3 marks)
Construct a payoff diagram, include maximum profit, maximum loss, and breakeven points on the diagram — show all workings (3 marks)
Evaluate the performance of your strategy on expiry (18th May 2023) and provide your calculations of overall profit and loss, % return, comparison to a relevant benchmark and reflect on the results, including sources of ineffectiveness in the strategy
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