In this assignment, you will study the Australian option market and apply option pricing models to assess the efficiency of the market. You will form a group of 2 to 4 students and work together on Task 1 to Task 3. You will then work independently on Task 4 to Task 6. Detailed submission instructions will be provided in Week 9. Group tasks: 1. Select a stock listed on the ASX: a. Prepare a table which contains the exercise (strike) prices, maturity dates, option prices (premiums) and open interest, for five matched pairs of options (put and call) on the stock. The put and call options in each matched pair should have the same maturity and the same exercise price. The maturity dates and strike prices for the five matched pairs should be approximately representative of the range of available maturities and strike prices. Make sure that one of your calls and one of your puts has a maturity date of at least six months, a strike price at, or close to, the money and has an option price that is not a stale price. b. Repeat part a above, for the option on the S&P/ASX 200 Index. c. There are three key differences between the ASX specification for an option on a stock and the option on the index. Prepare a table, with a column for the option on the stock and a column for the option on the index, and three rows that show the difference in specification between the two types of option. 2. Considering only the five pairs of options on the stock: a. Which is the most liquid put and which is the most liquid call? Explain your criteria for the assessment of liquidity. 2 b. Theoretically, how should the option prices behave as the strike price and maturity of the option change? c. With respect to maturity and strike prices, explain whether the actual option prices behave in the way predicted by the theory. If they do not, why do you think this is the case? 3. Show whether put call parity holds for the five pairs of options on the stock. If it does not hold, why do you think this is the case? Show calculations and explain your choice of interest rates for this analysis. Individual tasks: 4. Using historic information on returns, compute the standard deviation of returns on the underlying stock for the options that you have selected. Explain what data you used and show your calculations. 5. For your selected put and call that have a maturity of at least six months that are at, or close to, the money and that have an option price based on current trades: a. Using your estimate of the stock volatility from part 4, value the put and the call. Use the BlackScholes option pricing model. Show details of your calculation. b. Explain what adjustment, if any, that you made for dividends. c. How does your valuation compare with the actual prices? d. What value for the standard deviation gives a value that most closely matches the actual prices? 6. For your selected put and call that have a maturity of at least six months that are at, or close to, the money and that have an option price based on current trades: a. Using your estimate of the stock volatility from part 4 value the call. Use the risk neutral method with a binomial tree. Make three estimates of the value of the call, using 1, 2 and 3 steps respectively to value the call. Provide details of the calculations and the binomial trees. b. Explain what adjustment, if any, that you made for dividends. 3 c. Compare the estimates of the call value using the risk neutral method with the estimate of the call value from the Black Scholes method. What do you conclude from this comparison?