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ASC520 Financial Economics I Assignment UITM Answer Malaysia 

ASC520 Financial Economics I is a course offered at UITM (Universiti Teknologi MARA) in Malaysia. The course focuses on introducing students to derivative market products and their significance in the financial industry. Students will gain an understanding of the theoretical foundations, pricing mechanisms, strategic considerations, and formula derivation relevant to these products. The ASC520 course emphasizes the practical application of these concepts in real-world business scenarios.

By studying ASC520 Financial Economics I, students will develop a solid foundation in financial economics and gain insights into the complexities of the derivative market. The course aims to equip students with the knowledge and skills necessary to analyze and evaluate various financial products and their associated risks. Throughout the course, students will engage in problem-solving exercises, case studies, and discussions to enhance their understanding of the subject matter.

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Assignment Task 1 :Explain the basics term of financial markets structure.

The financial market structure refers to the framework in which financial assets are bought, sold, and traded. It involves various participants, instruments, and institutions. Here are some key terms related to financial market structure:

  • Financial Markets: These are platforms where buyers and sellers trade financial assets such as stocks, bonds, currencies, and commodities. Examples include stock exchanges, bond markets, and foreign exchange markets.
  • Participants: Individuals, institutions, and entities involved in financial market transactions. They can be investors, traders, speculators, corporations, banks, and governments.
  • Primary Market: It is where newly issued securities are bought and sold for the first time. Companies raise capital by issuing stocks or bonds in the primary market.
  • Secondary Market: It is where already issued securities are traded among investors. Examples include stock exchanges like the New York Stock Exchange (NYSE) and NASDAQ.
  • Exchanges: Organized markets where buyers and sellers come together to trade standardized financial instruments. Exchanges provide transparency, liquidity, and a regulated trading environment.
  • Over-the-Counter (OTC) Market: It is a decentralized market where trading occurs directly between participants without a centralized exchange. OTC markets are less regulated and offer flexibility in trading customized instruments.
  • Financial Instruments: These are contracts that represent a financial asset. Common instruments include stocks, bonds, options, futures, and swaps. They provide investors with various investment opportunities and risk management tools.
  • Market Participants: They can be classified into four main groups: individual investors, institutional investors (pension funds, mutual funds, etc.), market makers (brokers, dealers), and speculators (hedge funds, proprietary trading firms).
  • Clearing and Settlement: The process of ensuring that the terms of a trade are fulfilled, including the transfer of funds and ownership of assets. Clearinghouses and settlement systems play a crucial role in ensuring smooth and secure transactions.
  • Regulation and Oversight: Financial markets are subject to regulatory bodies that establish rules, monitor activities, and protect investors. Examples include the Securities and Exchange Commission (SEC) in the United States and the Financial Conduct Authority (FCA) in the UK.

Understanding these basics of financial market structure provides a foundation for comprehending the complexities of trading, investing, and risk management.

Assignment Task 2 :Create and describe the different types of derivative instruments and its strategies.

Derivative instruments are financial contracts whose value is derived from an underlying asset. They are used for hedging, speculation, and arbitrage. Here are some common types of derivative instruments and their strategies:

  • Futures Contracts: These are agreements to buy or sell an asset at a predetermined price and date in the future. They are commonly used for commodities, currencies, and financial instruments. Strategies include hedging against price movements and speculating on future price changes.
  • Options: Options provide the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specific price (strike price) within a certain period. Strategies include covered calls, protective puts, straddles, and spreads. Options can be used for hedging, income generation, and leverage.
  • Swaps: Swaps involve the exchange of cash flows between two parties based on specified terms. Common types include interest rate swaps, currency swaps, and commodity swaps. They are used for managing interest rate risk, foreign exchange risk, and hedging.
  • Forwards: Similar to futures contracts, forwards are agreements to buy or sell an asset at a future date. However, forwards are customized contracts traded over-the-counter (OTC). They are commonly used for non-standardized assets and can be tailored to meet specific needs.
  • Swaptions: Swaptions are options on interest rate swaps. They provide the right to enter into a swap at a future date. Swaptions are used for hedging against interest rate movements and taking advantage of potential changes in rates.

Derivative strategies vary based on investors’ goals, risk appetite, and market conditions. They can involve combinations of buying, selling, and hedging positions to achieve desired outcomes.

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Assignment Task 3 :Apply the concept of derivative pricing models, types, strategies, rational valuation and computation of derivative securities.

Derivative pricing models are mathematical formulas used to determine the fair value of derivative instruments. These models take into account factors such as the current price of the underlying asset, time to expiration, expected volatility, interest rates, and dividends. 

Here are some key concepts related to derivative pricing models:

  • Types of Models: There are various pricing models used for different types of derivatives. The most common models include the Black-Scholes model for options, the Binomial model for options, and the Black model for interest rate options.
  • Rational Valuation: Derivative pricing models are based on the principle of rational valuation, which assumes that the market price of a derivative reflects its fair value. The models help determine if a derivative is overvalued or undervalued, providing insights for trading and investment decisions.
  • Input Parameters: Derivative pricing models require input parameters such as the current price of the underlying asset, volatility, time to expiration, risk-free interest rate, and dividend yield (if applicable). These parameters affect the calculated fair value of the derivative.
  • Implied Volatility: Implied volatility is the level of volatility implied by the market prices of options. Derivative pricing models can be used to calculate implied volatility from option prices or vice versa. Implied volatility reflects market expectations and plays a crucial role in pricing options.
  • Numerical Methods: Derivative pricing models often involve complex mathematical equations that require numerical methods for computation. These methods include Monte Carlo simulation, finite difference methods, and binomial tree models.
  • Sensitivity Measures: Derivative pricing models provide measures known as “Greeks” to assess the sensitivity of option prices to various factors. Common Greeks include Delta (sensitivity to the underlying asset price), Gamma (sensitivity of Delta to underlying price changes), Theta (sensitivity to time decay), and Vega (sensitivity to changes in volatility).

Derivative pricing models help market participants make informed decisions by providing fair values and risk measures for derivative instruments.

Assignment Task 4: Formulate and use the binomial option pricing model to compute the option prices for a variety of underlying assets.

The binomial option pricing model is a popular method for pricing options based on a discrete-time framework. It assumes that the price of the underlying asset can move only up or down during each time step until the option’s expiration. 

Here’s how the model works:

  • Binomial Tree: The model uses a binomial tree to represent the possible future price movements of the underlying asset. Each node in the tree represents a price level at a specific time step.
  • Up and Down Movements: At each time step, the underlying asset price can either move up or down by a predetermined factor. These factors represent the expected volatility of the underlying asset.
  • Probability Calculation: The probabilities of up and down movements are calculated based on the risk-neutral assumption. The risk-neutral probability is derived from the risk-free rate of interest and the expected return of the underlying asset.
  • Option Valuation: Starting from the last time step, the option value at each node is calculated by discounting the expected future cash flows. For a call option, the value at each node is the maximum of the discounted expected option payoff or zero. For a put option, it is the maximum of the strike price minus the discounted expected asset price or zero.
  • Backward Iteration: The option values are calculated iteratively, moving backward through the tree until reaching the initial time step. At the initial node, the calculated option value represents its fair price.

The binomial option pricing model provides an efficient way to compute option prices for a variety of underlying assets. It is particularly useful for options with early exercise features and can accommodate dividend payments.

Assignment Task 5 :Analyse and calculate the price of European options using the Black Scholes formula for different underlying assets and measure the behaviour of the option price with a varying Option Greeks.

The Black-Scholes formula is a widely used model for pricing European options, which are options that can only be exercised at expiration. The formula takes into account various factors and assumptions to determine the fair value of an option. 

Here’s an overview:

  • Inputs: The Black-Scholes formula requires the following inputs: current price of the underlying asset, strike price of the option, time to expiration, risk-free interest rate, and expected volatility of the underlying asset.
  • Assumptions: The model assumes that the underlying asset price follows a geometric Brownian motion, there are no transaction costs or restrictions on short-selling, the risk-free rate and volatility are constant, and the markets are efficient.
  • Option Price Calculation: The Black-Scholes formula calculates the theoretical price of a European call or put option. For a call option, the formula is: Call Price = S * N(d1) – X * e^(-r * T) * N(d2), where S is the current asset price, N() is the cumulative standard normal distribution function, X is the strike price, r is the risk-free interest rate, T is the time to expiration, and d1 and d2 are intermediate variables.
  • Option Greeks: The Black-Scholes model provides sensitivity measures known as “Greeks” that indicate how option prices change with respect to various factors. The main Greeks are Delta, Gamma, Theta, Vega, and Rho. Delta measures the change in option price relative to changes in the underlying asset price, Gamma measures the change in Delta, Theta measures the change in option price over time, Vega measures the change in option price due to changes in volatility, and Rho measures the change in option price with respect to changes in the risk-free interest rate.

By using the Black-Scholes formula and understanding the behavior of option Greeks, market participants can assess the impact of different variables on option prices and make informed trading decisions.

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