Explain Risk Neutral behaviour and describe how it is different than Risk Averse and Risk Seeking behaviours in financial markets.

Feb 15, 2024

Explain Risk Neutral behaviour and describe how it is different than Risk Averse and Risk Seeking behaviours in financial markets.

Question 2

As a junior analyst, you have been tasked by your line manager to prepare supporting calculations in your report for a presentation to be made before Teachers Pension Fund’s management. These calculations should essentially demonstrate derivative pricing using the No Arbitrage Principle. To do so, you choose to demonstrate the pricing of futures and options contract on BT Group listed on Eurex Exchange. The line manager also wants to understand more about risk neutral pricing and expects you to provide some explanation of the underlying concepts.

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Required:

Estimate the fair price of any BT Group futures contract on Eurex using the cost of carry model. You are required to cover the following too:
provide (select and make assumptions) any missing inputs.
explain all the inputs in your pricing model and justify each.
compare the price from your cost of carry model against the actual price at the day close and explain any underlying reasons for the under-pricing or over-pricing. (8 marks)

1). Estimate the prices of both a BT Group call and a BT Group put option trading on Eurex Exchange using two and three period binomial option pricing models as well as the BSM model. You must cover the following:
provide (select and make assumptions) any missing inputs.
explain all the inputs in your pricing model and justify each.
evaluate whether the call and the put options are over or under-valued based on the price estimates from your calculations compared to their actual prices on Eurex Exchange. (12 marks)

2). For the two period binomial model, demonstrate that the estimated price of the call is fair using the hedge portfolio calculations over the two period and adjusting the hedge ratio accordingly. (4 marks)

Estimate the value of the risk free bonds from the put-call parity using first the prices of calls and puts from the BSM model in B above and then the actual prices of calls and puts available from Eurex Exchange for the same calls and puts. Discuss the factors that could explain the differences in pricing across the two put-call parity calculations. (6 marks)

Explain Risk Neutral behaviour and describe how it is different than Risk Averse and Risk Seeking behaviours in financial markets. Give relevant examples of each from financial markets. Why is derivatives pricing considered to be risk neutral? Explain. (10 marks)
(40 marks)
(Word limit 800)

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