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INVESTMENT ANALYSIS
1.
INTRODUCTION
Determining how and when to invest money to maximize returns is one of the
pressing issues that not only Chief Executive Officers (CEOs) have to face
nowadays, but also individual investors who want to make the best of their
assets.
It is obviously known that for an individual or a corporation that invests money to
make money, the success of the operation depends heavily on how well he/she
knows the game. The problem is that some people investing don’t know how to
invest in stock or are simply uninformed. In these conditions, investing becomes
a risky business where the risks can ruin the future of the corporation or an
individual life savings. This is true in any kind of investment such real estate or
stock market. For this project, the goal of our team is to elaborate a methodology
that would help investors to determine investment strategies that optimize returns
with index future options. The team came up with the following problem
statement.
Problem Statement:
Stock market has become one of the fastest growing segments of modern
economy. On a daily basis, millions of options are being traded for a value
equivalent to several billions dollars. As the investors and options are diversified,
so are the chances to make large profits but also risks of losing fortunes or
worse, have life saving assets vanished. Some of the reasons investors don’t get
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the maximum return are either they are unformed or ignore the rules of the game.
This team’s goal is to establish an investment methodology that would help
investors to maximize the returns on their investments with index future options.
Mission Statement:
Based on the problem statement, Team Investment developed a mission
statement to research, document and analyze the stock market options to
understand how it behave and from there to develop an investment strategy. The
following report details how the team developed and refined the problem, the
strategy adopted to conduct the project including the architecture and analysis.
Our mission statement is as follow:
Mission Statement:
Develop an architecture that can be applied to various stock options to
maximize returns on future index options. The main stages to be performed are:

Identifying some of the previous studies on the topic;

Applying known methodologies(Black-Scholes method) to
compute future prices;

Computing benefits from investment options by combining
strangles and straddles options;

Analyzing of the benefits trends when varying risk elements
such as strike prices, interests, volatility and exercise time.
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
Designing and implementing a strategic architecture that can be
used to determine how and when to invest for a net profit with a
relatively high probability.
2.
SCOPE DEFINITION
At the beginning the team has a very broad idea and vision of the project. The
comprehensive modeling of the project was very vague. It required several
meetings including long discussions with the sponsor to come out with a more
feasible version of the project that meet the expertise available and the time
allocated to the study. It is was agreed upon that only the following options will be
taken in account but one should keep in mind that the architecture to be
designed could be expended to other options.

Use of a known option pricing model;

S & P 500 index would be analyzed;

Libor volatility index would be used;

The team would be the seller of call and put options;

Straddles and Strangles options will be mixed for the simulation.

Ten years of historical data from the Chicago Board Of Trade (CBOT) will
be utilized to model and validate the model;

The MatLab simulation software will be utilized for that effect
2.1 Team forming
Investment team is composed of four members with different background and
experiences in SE and OR to put in use for this project. Background and
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contributions of each team member is summarized in the Table below
Team Member
Kindle
Lee
Erik
Isaac
Background
OR Student
OR Student
SE Student
SE Student
Research Analyst
Research and
Development Specialist
IT Systems
Specialist
Program Analyst
Modeling
Modeling
Architecture Design
Architecture Design
Analysis
Programming
Requirements
Elicitation
Researches
Report
Website
Contributions
Schedule
Analysis
Presentation
2.2.
Report
Problem Development
The Team considered a wide range of different issues and problems centering on
stock market domain. The first step was to discuss with our sponsor to
harmonize our understandings of the stock market trades. Then the second step
was to conduct background researches on various studies and papers published
on the subject.
2.2.1. Researches and Selections
At the beginning of the project, the team spent several weeks performing
background readings and researches on the history and performance of the
stock market domain. The effort and time allocated to that segment of the project
gave us a deep understanding of the inside of stock market trades, the benefits
of the investment and also potential risks investors are asked to look for. The
following definitions and concepts are utilized all along in the stock market trades
and the team decided to recall some of them in the definition section below.
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2.2.2. DEFINITIONS
The stock trades started as early as 7th century BCE, but the modern stock
markets as it is known today started really in 1973 with the opening of the
Chicago Board Of Exchange (CBOE) and the development of Black-Scholes
model option pricing model the same year.
“In their simplest form, stock options are a contract between two parties that
expires at an agreed-upon time in the future. The contract purchaser is buying
the right, but not the obligation, to buy (a "call" option) or sell (a "put" option) an
asset (the "underlying") at a specific price, the strike price, on or before the
agreed-upon date. The contract seller is accepting the obligation to take the other
side of the transaction”. http://www.wisegeek.com/what-are-stock-options.htm
The key characteristic terms in stock market are:

Expiration dates is when the option contracts becomes null and void;

The strike price, also called exercise price, is the price at which the option
will be sold or bought in case the option holder decide to exercise his
rights to buy or sell.

European stock options are only exercised at the expiration date while the
Americana stock options can be exercised at any time before the
expiration date.

Stock market index is a method for measuring the performance of a
section of stock market. In other words, “it tracks the changes in the
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values of hypothetical portfolio of stocks. The weight of a stock in the
portfolio equals the proportion of the portfolio invested in the stock” [1].
The well known stock market indices within the United States are the Dow
Jones Industrial Average (DJIA) consisting in 30 blue-chip stocks, the
Standard & Poor’s 500 (S & P 500) index based on 500 different stocks.
Outside the US, the most important indices are the French CAC-40 index
based on 40 large stocks trading, and the Nikkei 225 Stock Average
based on a portfolio of 225 largest stocks trading in Tokyo, Japan.
2.2.3. RELATED STUDIES and BIBLIOGRAPHY
The list of papers and studies summarized here is not exhaustive. The papers
mentioned here have been selected because their content will form the
framework and extensively used in the course of the project. Among the papers
we will be using are
a) A Better Risk Gauge For Options Portfolios
b) Minimizing Your Risks of Ruin
c) Expected Option Returns
d) Why are Put Options So Expensive?
e) Speculation Strategies Using Investment in Options.
f) A Study of Option Pricing Models (Black-Scholes model)
http://hilltop.bradley.edu/~arr/bsm/model.html
A particular attention has been given to the last paper as the model
developed is the backbone of the project. Below is a summarized explanation
of the model.
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The paper introduces preliminaries studies in option pricing that led to the well
known Black-Scholes model published for the first time in 1973.
The Black-Scholes is a mathematical model of the market for am equity in
which the equity’s price is a stochastic process.
[http://en.wikipedia.org/wiki/Black%E2%80%93Scholes
Black and Scholes, the authors of the study, provide in fact improvements on
the previous models and “come in from of a proof that the risk-free interest
rate is the correct discount factor, and with the absence of assumptions
regarding investor’s risk preference”
[http://hilltop.bradley.edu/~arr/bsm/pg04.html]
The Black-Scholes model makes the following assumptions:

The stock pays no dividend during the option’s life;
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
European exercises are used;

Markets are efficient, meaning that the follow mostly the Markov
process in continuous time.
3.

No commissions are charged;

Interest rates remain constant and known;

Returns are lognormal distributed.
STAKEHOLDERS ANALYSIS AND REQUIREMENTS ELICITATIONS
Requirements engineering methodologies were used in eliciting requirements.
Figure xx illustrates the triggers, inputs, systems and outputs of the process.
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Maximize
Returns
B-S Model
S&P 500 index
Libor
Requirements
Analysis
Stakeholders
Requirements
Stock Market
Team Knowledge
WHO IS THE STAKEHOLDERS
WHAT ARE THE STAKEHOLDERS VALUES?
THEN PERFORM STAKEHOLDERS MAPPING (map with VALUES)
In order to formalize the relationship between the customer requirements and
functional requirements, a Quality Function Deployment (QFD) in the form of
a House of Quality was developed. This analysis helped the team understand
the interrelationship between functional requirements and to also to identify
technical priorities and benchmarks. In addition to the QFD, all stakeholders,
needs, wants, customer requirements and functional requirements have been
added to the Invest Team Enterprise Architecture, which is described in detail
in Section xxxx. This allows for stakeholders to be traced to specific functional
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requirements in the architecture, thus providing a means to assure through
the product development process that stakeholder needs and wants are met
per the value mapping. The Enterprise Architect package containing this
information can be found in Appendix XXXXX [ A-Mart Project]
High Level Requirements
 General Constraints
o Strategy Analysis (SA) shall focus on the sale of put and call options
(short strategies)
o SA shall analyze variations of the straddle and strangle strategies
o SA shall be applied to only S&P 500 index future options
o SA shall use the Black-Scholes model for estimating option prices
 Data Requirements
o SA shall analyze S&P 500 index futures data for at least the past 5
years
o SA shall incorporate historical market volatility indices
o SA shall incorporate a ratio to estimate and account for implied market
volatility
o SA shall incorporate historical LIBOR interest rates
o SA shall analyze call options up to a maximum of 100 points above the
daily index price
o SA shall analyze put options down to a minimum of 100 below the daily
index price
o SA shall incorporate stop-loss point ranging from 20 to 40 point losses
o SA shall analyze 45 days of trading for each month
 Functional Requirements
o SA shall determine the straddle or strangle combination with the
highest average return
 Resource Requirements
o SA shall be compiled using a math modeling software program
o SA shall function on a 64 bit operating system
o SA shall function on a computer with at least 4 GB of RAM

Verification Requirements.
- specifies tests to be done during development, test data, test
documentation to be delivered.
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
Acceptance Testing.
- specifies the tests that will be used as the basis for user
acceptance of the system.

Documentation Requirements.
- documentation to be delivered during development.
- docn. that will be part of system e.g. User Manuals, Maintenance
Manuals, etc.

Quality Requirements.
- may specify production and adherence to a Quality Assurance Plan,
- may require supplier to have achieved a Q.A. standard, e.g. BS 5750
- change control requirements; configuration management.

Maintainability Requirements.
Specifies attributes of the system that affect the ability to
- trace and repair defects
- make modifications.
e.g. for software:
- modularity,
- use of object-oriented programming,
- built-in self test,
4.
Enterprise Architecture Documentation
4.1 Project Analysis
4.2. Requirements and Stakeholders Analysis
4.3. Architecture Paradigm
Behavioral Model
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Structural Model
Network Neighborhood
Simulation Model
Executable Architecture Selection
5.
The project.
5.1. The Model
5.2. Data inputs
5.3. Data Outputs
6.
Data Analysis
6.1. Parametric Analysis
6.2. Sensitivity Analysis
7.
Future Related Works
8.
General Conclusion
9.
Bibliography
10. Annexes/Appendices
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