Financial Education Association

Financial Education Association
The Binomial Pricing of Options on Futures Contracts

Author(s): R. Stafford Johnson, Richard A. Zuber and John M. Gandar
Source: Journal of Financial Education, Vol. 34 (FALL 2008), pp. 59-87
Published by: Financial Education Association
Stable URL: http://www.jstor.org/stable/41948841
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The
Options
Binomial
on
Futures
Pricing
of
Contracts
R. StaffordJohnson,Richard A. Zuber and JohnM. Gandar

atCharlotte
andU. ofNorthCarolinaatCharlotte
XavierUniversity,
U. ofNorthCarolina
oftheBinomialOptionPricingModel (BOPM) byCox,Rossand

Thederivation
Rubinstein(1979) and Rendlemanand Bartter(1979) are consideredimportant
to thefnancialliterature.UnliketheBlack-Scholes
pedagogicalcontributions
(B-S)model,whosederivation
requiresstochasticcalculusand a heatexchange
the
binomial
model
is
simplerto deriveand yetstillyieldsthesame
equation,
as
B-S
model
solution the
(when the numberof subperiodsto expirationis
providea formalderivationofthe
large).As a result,mostderivativetextbooks
BOPM. Today,thederivative
marketfornon-stockoptions(indices,currencies,
debt securities,and commodities)is dominatedmore by optionson futures
ofthe
contracts
thanoptionson spotsecurities.Unlikethedetailedpresentation
binomialmodelforspotoptions,though,mostof thepopularderivativetexts
onlydefinethebinomialmodelforpricingfuturesoptions.Like thederivation
oftheBOPM forspotoptions,thederivationofthebinomialmodelforfutures
optionshas similarpedagogicalvalues.In addition,thederivationoftheBOPM
forfuturesoptionsalso showshow different
arbitragerelationsgoverningthe
pnce ofa
pricesoffuturesand optionsconvergeto determinetheequilibrium
for
futures
contract
and
how
the
exercise
futures
option
advantage
options
early
dependson whetherthe futuresmarketis normalor inverted.Thispaper
presentsa derivationoftheBOPM forfuturesoptions.
INTRODUCTION
In 1979,Cox,Ross,and Rubinsteinand Rendlemanand Bartterderivedtheseminal
BinomialOptionPricingModel (BOPM). Theirderivationsare consideredimportant
to the financialliterature. Today, the derivationof the
pedagogicalcontributions
binomialmodelforpricingspotoptionsis standardin all derivative
texts,as wellas many
investment
books.Forfinancestudents,learningthederivationofthebinomialmodel
thepricingofoptions.The derivation
oftheBOPM also
providestheintuition
underlying
students
an
for
Excel
for
gives
spreadsheets valuingoptions,whichas
algorithm writing
a teachingtool,can add depthto a student'sunderstanding
ofderivativepricing.Finally,
Fall 2008
59
in additionto itspedagogicalvalue,thediscretebinomialmodelis themostwidelyused

modelforpricingAmericanoptions.
Today, the derivativemarketfor non-stockoptions (indices,currencies,debt
securities,and commodities)is dominatedmoreby optionson futurescontractsthan
ofthebinomialmodelforspot
Unlikethedetailedpresentation
optionson spotsecurities.
derivative
texts
most
of
the
options,though,
popular
(e.g., Hull (2006), Chance and
Brooks(2007),and Kolband Overdahl(2007))onlydefinethebinomialmodelforpricing
futuresoptions.The derivationofthe binomialmodelforfuturesoptionsnotonlyhas
similarpedagogicalvaluesas thederivationoftheBOPM forspotoptions,butalso has
some additionalones. First,the binomialderivationof futuresoptionsshows the
- spot,futures,
and options.As with
threemarkets
arbitrage
pricingrelationsgoverning
all derivatives,
theunderlying
economicbehaviorgoverning
thevaluationofa derivative
is arbitrage.In thecase ofa futuresoption,an arbitrageopportunity
mayexistbecause
botha futures
contractcanbe replicatedwitha spotpositiondefinedbythecarrying-cost
modeland an optionon thefutures
contractcan be replicatedbypositionsin thefutures
contractanda risk-free
The
oftheBOPM forfutures
security. derivation
options,inturn,
showshow thesearbitragerelationsconvergeto determinethe equilibriumpriceofa
futuresoption. Second, the binomialderivationhighlightshow the early exercise
advantageforfuturesoptionsdependson whetherthefuturescontractis normal(with
futurespricesexceedingspot prices)or inverted(with spot pricesexceedingfutures
of the upwardand downwardparametersforfutures
prices).Third,the specification
rateand assetyieldbecome
optionsshowsnotonlyhow themean,butalso therisk-free
for
the
case
of
a
a
number
of
unimportant
subperiods.Seeingthishelpsfinance
large
studentsunderstand
the
risk-free
rate
and
asset
yieldareabsentin theequationfor
why
in
the
Black
futures
model.
d
option
Finally,giventhe varietyof futuresand futures
debtsecurities,
and indices- thederivation
currencies,
optioncontracts commodities,
of the binomialprovidesa usefultool forstudyingnon-stockderivativesand their
interrelationship.
Givenboththepedagogicalandpracticalvalueofthebinomialmodel,alongwiththe
growingpopularityoffuturesoptions,thispaperpresentsa derivationofthebinomial
andclassroompresentations
ofthe
modelforpricingfutures
options.Likemosttextbooks
binomialmodelforspotoptions,theprimary
focusin thederivationis thesingle-period
the arbitragerelations
model.In the case of futuresoptions,thisinvolvesidentifying
two-state
caseandspecifying
andfutures
spot,futures,
optionsina one-period,
governing
the estimating
formulasforthe upwardand downwardparameters.In Section3, the
binomialmodelfora genericfutures
optionis derivedusingthereplication
single-period
and
the
formulas
for
approach
estimatingupward and downwardparametersare
specified(the derivationsof the up and down parametersare presentedin the
modelis thenextendedin Section4 to the morepractical
appendix).The single-period
binomial
model
forfuturesoptions.Forfuturesoptions,the multiplemultiple
-period
model
how
the
period
highlights
earlyexerciseadvantageforAmericanoptionsdepends
on whetherthefuturesmarketforthecontractis normalor inverted.Also in Section4,
60
Journal of Financial Education
examplesof the binomialpricingof Americanand Europeanoptionson an S&P 500

futurescontractforbothnormaland invertedmarketcases are presented.We begin
witha shortdescription
ofthemarketforfuturesoptions.
MARKET FOR FUTURES OPTIONS
A call optionon a futures
contractgivestheholdertherightto takea longposition
intheunderlying
futures
contract
whensheexercises,andrequiresthewritertotakethe
shortpositionin the futures.Upon exercise,the holderofa futurescall
corresponding
in
effect
takesa longpositionin thefuturescontractat thecurrentfutures
option
price
and the writertakesthe shortpositionand paysthe holdervia the clearinghousethe
difference
betweenthe currentfuturespriceand the exerciseprice.In contrast,a put
optionon a futuresoptionentitlesthe holderto take a shortfuturespositionand the
writerthelongposition.Thus,whenevertheput holderexercises,he in effecttakesa
shortfutures
positionat thecurrentfutures
priceand thewritertakesthelongposition
and paystheholdervia theclearinghouse
thedifference
betweentheexercisepriceand
the currentfuturesprice. Like all optionpositions,the futuresoptionbuyerpaysan
optionpremiumfortherightto exercise,and thewriter,in turn,receivesa creditwhen
he sellstheoptionand is subjectto initialand maintenancemarginrequirements
on the
optionposition.
The currentU.S. marketforfuturesoptionsbegan in 1982 when the Commodity
FuturesTradingCommission(CFTC) initiateda pilotprogramin whichit allowedeach
futures
exchangeto offerone optionon one ofitsfuturescontracts.In 1987,the CFTC
the
to offerfuturesoptions.Currently,
the most
gave
exchangespermanentauthority
popularfuturesoptionsare theoptionson financialfutures:S&P 500, T-bond,T-note,
Eurodollardeposit,and themajorforeigncurrencies.In additionto optionson financial
futurescontracts,
futuresoptionsalso are availableon gold,preciousmetals,livestock,
andoil. Manyofthesecontracts
haveexpiration
food,fiber,
months,
petroleum,
position
and
contract
similar
to
their
limits,
specifications
underlyingfuturescontracts.Some
futuresoptionscontracts,though,do not have the same expirationdate as their
futurescontract.
underlying
In general,spotand futuresoptionsare equivalentifthe optionsand the futures
contracts
thepriceoffutures
modelgoverning
expireatthesametime,thecarrying-cost
holds,and the optionsare European.There are, though,severalfactorsthatserveto
differentiate
the two contracts.First,since mostfuturescontractsare relativelymore
than
their
liquid
spot security,it is usuallyeasier to formhedgingor
corresponding
with
futures
arbitrage
optionsthanwithspotoptions.Second,futures
options
strategies
oftenare easierto exercisethantheircorresponding
spot.For example,to exercisean
futures
one simplyassumesthefutures
contract,
optionon a T-bondorforeigncurrency
a
T-bond
or
a
position;exercising spot
foreigncurrencyoption,though,requiresan
actual purchaseor delivery.Finally,most futuresoptionsare traded on the same
exchangeas theirunderlyingfuturescontract,while mostspotoptionsare tradedon
Fall 2008
61
fromtheirunderlying
securities.This,in turn,makesit easierfor
exchangesdifferent
futures
and hedgingstrategies
thanspotoptions
optionstradersto implementarbitrage
traders.
SINGLE-PERIOD BINOMIAL OPTION PRICING MODEL FOR FUTURES OPTIONS
In thebinomialoptionpricingmodel(BOPM), theequilibriumpriceofan optionis
basedon thelaw ofone price.Thispriceis foundbyequatingthepriceoftheoptionto
thevalueofa replicating
thatis,a portfolio
constructed
so thatitspossiblecash
portfolio;
flowsare equal to theoption'spossiblepayouts.To construct
a replicating
for
portfolio
futures
assume
that
in
the
futures
one
and
at
the
options,
initially
optionexpires
period,
end of the period,thereare only two possiblestates.In this one-period,two-state
economy,assume thatat the end of the period,the price on the futurescontracts
u timesits
asset,thespotprice(S0),willeitherincreaseto equal a proportion
underlying
initialpriceoritwilldecreaseto equal a proportion
d timesitsinitialvalue. Forfinancial
therelationship
betweenthefuturesprice(f) and spotprice,as definedbythe
futures,
is:1
model,
carrying-cost
io = V
where:
(1)
contract
nf= numberofperiodsto expirationon thefutures
r = 1 + periodicrisk-free
rate
Dt = value ofbenefits(e.g.,dividendsor interest)on theunderlying
assetto be realizedat expiration
Giventhe two possiblespotprices(Su = uS0and Sd= dS0),thetwo possiblefutures

modelare:
pricesat theend oftheperiod(fuand fd)usingthecarrying-cost
The possiblepricesofthe call and put optionon the futurescontractwithan exercise

values;
priceofX and expirationat theend ofone periodwill be equal to theirintrinsic
or Cd = Max[fd-X,0],
and Pu = Max[X-fu,
0] or Pd= Max[X-fd,
0]:
Cu = Max[fu-X,0]
62
Journalof Financial Education
Cu = Maxfo-XO]
Pu = Max[X-fu ,0]
^
c0
P
'
Cd = Maxfo-X,0]
Pd = MaxfX-fj ,0]
's
Giventhepossiblepriceson thefuturescontractand futuresoptionsat the end of

period1,thecurrentequilibriumpriceon thecall,C0,or putoption,P0,on thefutures
contractis foundbyconstructing
a replicating
withcash flowsthatmatchthe
portfolio
futurescall option'spossiblevalues of Cu and Cd or the futuresput option'spossible
valuesof Pu and Pd. The replicatingfuturescall portfolio(RPC) is formedby takinga
atf0andborrowing
contracts
orinvesting
the
positionin Hf0futures
B0dollars.Similarly,
in
futures
is
formed
a
futures
put portfolio(RPP)
by taking position Hf0
replicating
contracts
at f0and investing
orborrowing
I0dollars.The possiblevaluesoftheportfolios
are:
RPC=H,(fd-f0)-rB0
I
RP c - HqVq
B0 = Hq(0)
B0
=
RPp HqVQ 10 HQ(0) + 10
1 /
/
I
v
IX
RPp =Hj(fu
RPC
Hq (fu
-f0) + rl0
f0)
1
1
rB0
RPp =Hg(fd -f0) + rl0
Forthefutures
call,theequilibrium
priceis obtainedbysolvingfirstfortheH0 and
that
make
the
two
B0
possiblereplicatingportfoliovalues at expirationequal to the
possiblecall values and then settingthe price of*the call equal to the value of the
p
definedin termsofH0 and B0 . Thatis:
portfolio
replicating
Hi(f-fo)-B0r
= Cu
Fall2008
63
H;(f<,-f0)-B0r
(2)
C<1
Cd
f. _
~ Cu
0
f _f
ru
d
Cu (fd
B =
Hq V
f0 )
Cd (fu
f0 )
(4)
=
C
HS"(0)-B
*
*
C0
_B0
(5)
+ Cd(fu-f0)
R _-Cu(fu-f0)
D0
r '
(C
r(fu -fd)
r-_ ^0
Note,thefuturescontracthas no initialvalue (Vf0= 0).

Givenfd< f0,thefirstbracketedexpressionin Equation(5) is negative,implying
C0*
is positiveand also implyingH0Pis positive.If the marketpriceofthe call,Cm0,is not
equal to C 0, an arbitrageportfolioconsistingof a positionin the call and an opposite
positionin thereplicating
portfoliocan be formedto takeadvantageofthismispricing
thearbitrage
would
Forexample,ifthefutures
call is overpriced,
portfolio
opportunity.
f
in
a
in
a
risk-free
and
an
investment
of
dollars
require
security
long position H0
B0
futurescontracts.
Forthefutures
put,theequilibriumpriceis obtainedin a similarwaybysolvingfor
f>
theH0 and I0 thatmaketwo possiblereplicating
valuesat expiration
portfolio
equal to
to
the
value
of
theirtwo possibleputvaluesand thensettingtheprice
of
the
putequal
p
in
thereplicating
defined
terms
of
and
:
portfolio
H0
I0
H;(fu-f0)+I0r=Pu
H;(fd-f0)+I0r
<6)
Pd
P - P
Ho =tzr
K
64
(7)
.
L =
[Pu(fd-fo)-Pd(f-fo)]
r(fu-fd)
p;
p;
p
=
=
=
Hq v0f + 1;
H0r(o)+i;
i;
pu(fd-f0)-pd(fu-f0)]
(C
c '
r(fu"fd)
n._T._
~
~
0
0
Givenfd< f0,10 and P0 are therefore

positive,and H0 is therefore
negative.Ifthe
marketpriceof the put,Pm0,is not equal to P 0, an arbitrageportfolioconsistingof a
can be formedto
positionin theputand an oppositepositionin thereplicating
portfolio
take advantageof this mispricingopportunity.
In the case of an overpricedput,the
in
contractand an investment
portfolio
requiresa shortpositionin thefutures
arbitrage
therisk-free
security.
Both the equilibriumcall price Equation (5) and put price Equation (9) can
be expressedin termsoftherisk-neutral
the
alternatively
(p) bysubstituting
probability
for
A
and
for
the
equation fu,fd,
carrying-cost
algebraicderivation).
f0(see Appendix
Forfinancialfutures,
theresulting
call and putequationsare:
c;
-[pcn
+ (i-p)cd]
,r
P
where:
(10)
-[pPu+(l-p)PJ
r
p = [r-d]/[u-d]
Cu = Max[fu-X,0]
Cd= Max[fd-X,0]
Pu= Max[X-fu,0]
Pd= Max[X-fd,0]
Fall 2008
65
PointsOn BOPM For FuturesOptions

Severaltechnicalpointsconcerning
thebinomialpricingoffinancialfutures
options
shouldbe noted.
1. Forcall andputoptionson a currency
futures
theequationforp includesthe
contract,
=
interest
rate:
foreign
rF (1+RF):
_ rus
rF^
rF[u-d]
2. Mostderivativetextsdefinethecarrying
costmodelforindexand currencyfutures,
as well as theequationforp, forthecase ofa continuousdividend(or asset)yield.3The
assumptionof a continuousassetyieldis moreapplicableforpricingspotand futures
indicesand is easilyappliedto thepricingofcurrencyderivatives.
In thecaseofan index
or currencyoption in which the stock index or currencyis adjustedto reflecta
continuousdividendyieldora continuouscompoundedforeign
risk-free
rate,thefutures
is:
price
(RA-yOnfAt
f _C
~~
ro
oe
where:
rate
'>= annualdividendyieldor foreignrisk-free
RA= annualizedrisk-free
rate(U.S. rateforcurrencyoption)
At= lengthofbinomialstepsas a proportion
ofa year
=
nf numberofperiodsto expiration
In thiscase,the equationforp includesthe annualdividendor foreignrisk-free
yield.
Definedin termsofannualizedparameters,
p is:
P~
e(RA-^)At_d
u-d
3. In theBOPM forspotoptions,theformulas
forestimating
u andd arefoundbysolving
forthe u and d valuesthatmake the expectedvalue and the varianceofthe binomial
distribution
ofthelogarithmic
returnoftheunderlying
security'spricesequal to their
estimated
and
under
the assumptionof an equal
values,
a,
respective
parameter
(a
of
the
in
one
thatthedistribution
probability
security
period(orequivalently
increasing
of the logarithmic
returnis normal). The formulavalues foru and d thatsatisfythis
conditionare:
66
u
J
_
_
e^V
t+Ât
Vt+/Ât
~as
where:
A
annualizedstandarddeviationofthespotprice'slogarithmic
return
"s = estimated
A
return
JU = estimatedannualizedmeanofthespotprice'slogarithmic
At = thelengthofthebinomialperiod= t/n,where:t = timeto expirationas a
ofa yearand n = numberofperiodsto theoption'sexpiration
proportion
4. The binomialmodelforoptionson financialfutures
is definedin Equations(5) and (9)
in
terms
of
the
and
down
fortheunderlying
(orEquation(10))
up
parameters
spotprices.
It is commonto also definetheup and down parameters
in termsofthefuturesprices,
f
u andd . Specifically,
ifthecarrying-cost
modelholds,thentheformulas
forestimating
theup and downparameters
and risk-neutral
probability,
pf,as definedin termsofthe
futures
priceare:
uf
_
e<TfAVt+//fAAteCTsAVt+/^-(RA-iiOAt
(11)
_
Vt+//A-(RA-^)At
g-crA Vt+/ifÂt g-crA
(12)
l-df
<13)
where:
<7^ and
= annualizedstandarddeviationand meanon thefuturesprice's

return
logarithmic
The relationships
betweenthe volatilityand mean on the futuresprice'slogarithmic
returnand thespot'svolatilityand mean,in turn,are:
^_A -_
Fall 2008
67
~ (RA v)
t = s
A moredetailedexplanationoftherelationship
betweenthefutures
andspotupwardand
downwardparameter,includingthe algebraicderivationof Equations(11) - (15), is
presentedin AppendixB.
f
f
5. Note thatsinceu and d (Equations(11) and (12)) includethe risk-free
rateand the
dividendyield,p (Equation(13)) is determined

both
at
least
fordiscrete
by
parameters,
cases in whichthereare a smallnumberofperiodsto expiration.Fora multiple-period
rate
modelthatis definedby a largenumberofsubperiods,the impactoftherisk-free
and dividendyieldon theoptionpriceis small.Specifically,
as thenumberofsubperiods
increasesorequivalentlyas thelengthofthebinomialperiodAt(= t/n)becomessmaller,
the secondtermin the exponentofEquations(11) and (12) - a termthat includesnot
rateand dividendyield- goesto zerofasterthan
onlythemean,butalso therisk-free
theequationsforu
thesquarerootterms.As a result,fora largenumberofsubperiods,
and d simplify
to:
uf = eÂvs
= u
df = e-<rsAV5T = d
f f
f
and thereforeall threeterms- p , u and d - are absentof the risk-free
rateand
dividendyield.Thus,forthecase oflargen,theonlyinputthatneedsto be estimatedto
contractis theunderlying
futures'
determine
thepriceofan optionon a financialfutures
spotvariability
as.
In summary,
forfinancialfutures
thesingle-period
binomialequationsdefining
the
in
for
call
and
on
a
futures
contract
are
similar
form
to
the
equilibriumprices
putoptions
BOPM forthespotsecuritiesexceptforCu and Cd and Pu and Pd,whichare definedin
termsof the contractpriceson the futuresinsteadof the spot prices. If the futures
contractand thefuturesoptionexpireat thesametime,thenthepossiblepriceson the
futures
willbe equal to thepossiblespotprices(fu= Suand fd= Sd);
contractat expiration
in thiscase,Cuand Cdand Puand Pdwill be thesameforthespotoptionand thefutures
option.Thus, if the futurescontractand the option have the same expiration,the
model holds,and the futuresand spotoptionsare both European,then
carrying-cost
futuresand spotoptionswill be equivalent.
68
BOPM Examples
Single-Period
PricingA Call And Put On A StockIndexFutures
As an example,considera 1250 Europeancall and put optionson a stockindex
futures
contract.Assumethefuturesoptionsexpireat theend ofone period,while the
indexfuturescontractexpiresat the end of two periods(nf= 2). Also assumethe spot
ofu = 1.1 and d = .95, the
indexis currently
at 1250 and has up and down parameters
rateis 5%, dividendspaidon thestockscomprising
theindexareworth
periodicrisk-free
and
the
futures
is
determined
12.50at thefutures
price
expiration,
bythecarrying-cost
model.
the currentfuturespriceon the indexfuturescontract
Giventheseassumptions,
we willassumeno multiplier)
and as shownin Exhibit
wouldbe 1365.625(forsimplicity
1 thepossiblepriceson thecontractnextperiodwouldbe fu= 1431.25and fd= 1234.375,
andthepossiblevaluesofthefutures
call optionexpiringat theend oftheperiodwould
be 181.25or zero (see Exhibit1(a)) and the possiblevalues of the futuresput option
expiringat theend oftheperiodwould be zero or 15.625(see Exhibit1(b)). Usingthe
BOPM, theequilibriumpriceofthe 1250call optionon theindexfutures
single-period
contractis 115.08and theequilibriumputpriceis 4.96 (see Exhibit1).
Ifthemarketpriceon the futurescall or putoptiondoes notequal itsequilibrium
will existbytakinga positionin theoptionand an
value,thenan arbitrage
opportunity
oppositepositionin the replicatingportfolio.For example,in the above case, if the
marketpriceofthe 1250indexfuturescall is C0m=120 insteadofC0*= 115.08,thenas
showninTable 1,a risklessreturnof5.17 couldbe earnedatexpiration
bysellingthecall
=
=
for120,takinga longpositionin Hf0' [Cu-Cd]/[fu-fd]
[181.25-0]/[1431.25-1234.375]
= .920635indexfutures
contractsat f0= 1365.625,and investingamountsofB 0 =115.08
andC0m- C0 = 120-115.08= 4.92 in a risk-free
ofC0m= 120).
security(a totalinvestment
On the otherhand, if the marketprice of the futurescall is below 115.08,then an
is employedin whichC0m
dollarsareborrowedat
underpricedBOPM arbitrage
strategy
therisk-free
rateand used to financethepurchaseofthecall and thena shortposition
in Hf0*
futurescontractsis takenat f0.
In the case of the put, if the marketprice of the 1250 index futuresput were
overpricedat P0m= 10 insteadofP0*= 4.96,thenan arbitragecashflowof5.29 couldbe
earnedby sellingtheputfor10,takinga shortpositionin .079365indexfuturesat f0=
= -0.079365),and
= [0 - 15.625]/[1431.25-1234.375]
1365.625 (Hf0*= [Pu-Pd]/[fu-fd]
=
=
=
in
1
5.04
a
risk-free
amounts
of
4.96
and
10-4.96
investing
security(see
0
P0m P0
Table 2). On theotherhand,ifthemarketpriceofthefutures
putis below4.96,thenan
BOPM arbitrage
is employedin whichP0mdollarsareborrowedat
underpriced
strategy
therisk-free
ratewiththeproceedsused to financethepurchaseoftheputand thena
longpositionin H 0 futurescontractsis takenat f0.
Note,sincethe futuresand the futuresoptiondo not expireat the same time,the
priceof thefuturesoptiondiffersfromthepriceon an optionon thespotindex. For
Fall 2008
69
Exhibit1. BinomialPricingofIndexFuturesCall and Put Options
70
example,the equilibriumprice of a Europeancall optionon the spot indexwith an

exercisepriceof 1250and expiringat theend ofone periodis 79.36:
+ (1 - p)Cd]
c - ~[pCu
r
C =
f^t-6667Max[1375_
=
C'0 79.36
125.]+ (.3333Max[1187.5- 1250,0]]
The 1250futures
call optionalso wouldbe equal to 79.36 ifthefuturescontractexpired
at theend ofthefirstperiodinsteadofthe second (thiswould makeCu on the futures
option125 and therefore
C0 = 79.36).
PricingA Call On A StockIndexFuturesGivenA ContinuousDividendYield
In pricingthe futurescall on the S&P 500 futures,supposethe dividendson the
a continuouspayment.In thiscase,we can pricethe
spotindexapproximate
underlying
callandputoptionsand futures
usinga continuousdividend-adjusted
spotindex.To see
this,assumethefollowing:
The S&P 500 futures
optionexpiresin 90 days
The S&P 500 futures
contract
expiresat theendof 180 days
The current
=
index
is
spot
S0 1250
The estimated
annualizedvolatility
andmeanofthespotindex'slogarithmic
return
=
=
are asA .3 and |isA 0
The annualriskfreerateis Rf= .06
The futures
model
priceis determined
bythecarrying-cost
= continuousannualdividend
=
4%
yield
i|>
Ifwe pricethe futurescall optionusinga singleperiodmodel,thenthe lengthof the
binomialperiodin yearsis At= 90/365and 'i = 1.160637,d = .861596,rf= e<^907365ânc
p = .479358:
U=
= e'3V90/365
= 1.160637
d = l/u =.861596
(,06-.040)(90/365)
r _J
-*- == =
=.479358
p
u-d
1.160637-.861596
Fall 2008
71
Table 1. Single-PeriodArbitrageStrategy
foran OverpricedIndex FuturesCall Option
f0= 1365.625,% = 2
C0m=120,C0*=115.08
u = 1.1,d = .95,r = 1.05
Strategy:
SeHCall atl20
at 1365.625
Longin Hf0= .920635FuturesContracts
InvestB 0= 115.08in Risk-free
Security.
= 120-115.08= 4.92 in Risk-free
InvestExcessofC0m-C0<
Security.
CashFlowat Expiration
ClosingPosition
Call Purchase:-Q
1365.625)
ClosingFutures:.920635(fTInvestment:
B> = 115.08(1.05)
Investment:
(C^-Qr = 4.92(1.05)
= 1431.25,Cu= 181.25
-181.25
60.42
120.83
5JL7
5A7
fd= 1234.375,Cd= 0
0
- 120.83
120.83
5A7
5A7
in 180
costmodel,thecurrentfutures
priceon theindexexpiring
Usingthecarrying
=
are
1457.97
and
the
next
the
on
contract
is
period
fd=
days 1262.39, possibleprices
fu
at
the
end
of
the
futures
call
1082.32,and thepossiblevaluesof
period
optionexpiring
1 are 207.97 and zero.
rA )(nf-1)(At)=
1457.97
(1.60637)(1250)=
uS0e(
=
1250.0) = 207.97
X,0) = Max(1457.97
Cu
Max(fu
f0
=
dS0e(RA_,/)(nf"1)(At) (.861596)(1250)e(06"04X90/365)
=
1250.0) = 0
X,0) = Max( 1082.32
Cd
Max(fd
fd
72
= 1082.32
Table 2. Single-PeriodArbitrageStrategy
foran OverpricedIndex FuturePut Option
f0= 1365.625,% = 2
= 10,P0*= 4.96
P0m
u = 1.1,d = .95,r = 1.05
Strategy:
SeHCall at 10
Shortin Hf0= .079365FuturesContracts
at 1365.625
InvestI o= 4.96in Risk-free
Security.
= 10-4.96= 5.04 in Risk-free
InvestExcessofP0m-P0
Security.
CashFlowat Expiration
ClosingPosition
PutPurchase:-PT
ClosingFutures:.079365(1365.625-fT)
B 0r= 4.96(1.05)
investment:
= 5.04(1.05)
investment:
(C0m-C'0)r
^ = 1431.25,Pu= 0 fd= 1234.375,Cd= 5.625

0
-5.208
5.208
-15.625
10.416656
5.208
5.292
5.292
5.292
5292
Usingthe single-periodBOPM, the equilibriumpriceof the call optionon the index

futures
contractis 98.23:
c = ^r[pcu
e
Ci =
mLW
+ (1-p)cd]
[(-479358X209.97) + (,520642)(0)] = 98.23
Ifthemarketpriceofthefuturescall optiondoes notequal itsequilibriumvalue,then

an arbitrageopportunity
will existby takinga positionin the call and an opposite
positionin thereplicating
portfolio.
could be pricedin termsoftheup and down
Note,theindexfuturesalternatively
of
the
futures
parameters
prices(Equations(11), (12), (14) and (15)). In thiscase,uf=
=
df
1.154928,
.857357,and pf= p = .479358 (see Exhibit2).
Fall 2008
73
Exhibit2. BinomialPricingofIndexFuturesCall and Put Options
74
MULTIPLE-PERIOD BOPM FOR FUTURES OPTIONS

The above single-period
binomialcases help to illustratehow arbitragestrategies
contractsdeterminethepriceofa futures
usingoptionand futures
option.The practical
applicationofthebinomialmodeltopricingfutures
options,though,requiresa multiplea multiple-period
model,we dividethetimeto expiration
periodmodel.In constructing
intoa numberofsubperiodsofsmallerlength.As thelengthofthetimeperiodbecomes
smaller,theassumptionthattheassetpricechangesfollowa binomialprocessofeither
ordecreasingin eachperiodthenbecomesmoreplausible,and,as thenumber
increasing
ofperiodsincrease,the numberofpossiblestatesat expirationis greater,againadding
morerealismtothemodel.The multiple-period
binomialvaluesforEuropeanoptionsare
obtainedrecursively
theoptions'intrinsic
values(IV) at expirationand
bydetermining
thenusingthesingle-period
BOPM at each nodeto pricetheoptionsequal to thevalues
oftheirreplicating
portfolios:
=
"T
rf [j=0vn
X,)]
JJ-J*
P^
(-"jij.P'0
P)'n"[Maxi;X-
(M'"1'
f,0)]
The BOPM can be adjustedto valueAmericanoptions(Ca0and Pa0)bydetermining

whetherthereis an earlyexercisevalue at each node. This is done by constraining
the
=
optionpriceat each nodeto be themaximumofitsbinomialvalue or IV: Ca Max[C,fX] or Pa = Max[P,X-f],in whichP and C are thebinomialvaluesoftheputand call as
determinedby using the single-periodmodel with the two possible option prices
determined
forthenextperiod.
PricingS&P 500 IndexFuturesCall and Put Options
To illustrate
theapplicationofthemultiple-period
binomialmodelto thepricingof
futures
options,considerthepricingof Europeanand Americancall and putoptionson
an S&P 500 indexfutureseach withX = 1250 and T = 90 days,usinga three-period
binomialmodel. In pricingtheoptions,supposethefollowing:
The currentS&P 500 is at
S0= 1250
A
A
The
spotindex'sestimatedvolatilityand meanare as = .3 and |is =0
Theannualcontinuous
dividendyieldgenerated
fromthestockscomprising
theindex
=
is
.04
portfolio i>
Ra = 6%
The S&P 500 futures
contract
expiresin 120days
Fall 2008
75
= 0.082192,withthe
Thelengthofthebinomialperiodin yearsis At= t/n= (90/365)/3
= (3)(0.082192)= .246575years,and thefutures
in (n0ption)At
call and putoptionexpiring
=
=
in
At
.328767
on the
(4) (0.082192)
years.Usingtheup anddownparameters
expiring ^
=
is pf .488064:
futures
therisk-neutral
contract,
probability
uf _ e<xsVt+^-(RA-^)At
.3V.082192
+(0-(.06-.04)(.082192)
uf _ e
=1088024
jf _ g-cr^Vt+^-(RA-^)At
082192)_ 915Q8
_ e-.3V.082192+(0-(.06-.04X
,=
-d=
u -d
1-91608
1.088024-.91608
= 4g80<4
Exhibit3 showstheresulting
binomialtreefortheunderlying
S&P 500spotindex,S&P
500indexfutures,
and
American
futures
call
and
European
options, EuropeanandAmerican
futuresput options.For this three-period
optioncase, the binomialmodel pricesthe
Europeancall at 83.73and theAmericancall at 84.01and theEuropeanputat 75.61and
Americanputat 78.85.Thereis an earlyexerciseadvantagefortheAmericancall at the
uppernodeinperiod2,andan earlyexerciseadvantagefortheAmericanfutures
putatthe
lowernode in period2. As a result,boththeAmericanfutures
putand call optionsare
Forn = 30 subperiods,theprices
pricedslightly
higherthantheirEuropeancounterparts.
oftheEuropeanandAmericanS&P 500 futures
callsare77.04and 77.30,respectively;
for
and
69.11
table
at
the
the Europeanand Americanfutures
the
are
68.91
(see
put,
prices
4
bottomofExhibit3).
Exhibit4 showsthebinomialtreeforan S&P 500 indexfutures
atthesametimeas thefutures
options(90 days),alongwiththepriceson European
expiring
andAmericanfutures
callandputoptionsand EuropeanandAmericanspotindexcalland
put options.The spotS&P 500 indexoptionshave the same exercisepriceof 1250 and
of90 daysas do thefutures
options.The tableat thebottomofExhibit4 shows
expiration
inthecase
Asexpected,
thebinomialpricesofthespotandfutures
optionsfor30 subperiods.
ofEuropeanoptions,thefutures
andspotoptionpricesareidentical.
This,inturn,confirms
an earlierpointthatifthefutures
thespotoptioncontract,
andthefutures
contract,
option
andspot
contract
all expireatthesametimeandtheoptionsareEuropean,thenthefutures
As such,thepriceon thefutures
optionsareidentical.
optionisequaltothepriceonthespot
and
Price
differences
can
be
betweenthe Americanfutures
observed,
however,
option.
Americanspot options. In the three-period
case of the call options,the priceof the
Americanfutures
callis 89.89, whilethepriceoftheAmericanspotcallis 82.62,thesame
canbe explainedbythefactthatthe
as theEuropeanspotoptionprice.Thepricedifference
futurespricesare
76
BinomialPricing
Exhibit3. Multiple-Period
and
Put Options
ofIndexFuturesCall
= 120 Days
= 90 Days,FuturesExpiration
X = 1250,OptionExpiration
and also thepresenceofan earlyexercise

higherthanthespotpricespriorto maturity
advantageon the futuresoptionthatoccursat the uppernode in period2. Similarly,
an earlyexerciseadvantagealso existsforthe Americanfuturesput (lower node in
period2), butnot
77
Fall 2008
BinomialPricingofIndex
Futuresand SpotCall and PutOptionswithFuturesand
at theSameTime
OptionsExpiring
= 90 Days
78
fortheAmericanspotput.The Americanfutureputprice,though,is stillless thanthe

Americanspotbecauseofthefutures
As
pricesexceedingthespotpricespriorto maturity.
in
a result,
thepriceoftheAmericanfutures
this
is
less
than
the
of
the
put
example
price
Americanspotput.
In general,ifthefutures
marketis normalwithfutures
pricesgreaterthanspotprices
will
to
then
the
futures
be
thanthecorresponding
prior maturity,
prices
consistently
greater
in
As
a
an
American
futures
call
be
result,
will, turn, worthmorethanits
spotprices.
Americanspotcall.Conversely,
an Americanfutures
putwillbe pricedless
corresponding
thanitscorresponding
Americanspotputwhenthemarketis normal.As noted,thisis the
casein ourexample.Specially,
withtherisk-free
rateof6% exceedingthedividendyieldof
the
market
for
the
index
is
normal
with
futures
theS&P 500futures
the
4%,
pricesexceeding
at
all
nodes
to
the
binomial
model
spotprices
prior maturity.
corresponding
Accordingly,
call (76.04in the30-periodexample)morethantheAmerican
pricestheAmericanfutures
spotcall (75.79),and Americanfutures
putprice(69.93) lessthantheAmericanspotput
(70.41).
Ifthefutures
market
withthefutures
lessthanthespot
wereinverted,
priceconsistently
callwillbe less
thentheoppositewilloccur:TheAmericanfutures
pricepriorto maturity,
thantheAmericanspotcall and theAmericanfutures
will
be
pricedmorethanthe
put
Americanspotput.An exampleofan inverted
marketS&P 500 future
marketis presented
inExhibit5. The exampleis thesameas thepreceding
case(Exhibit4), exceptthattheriskfreerateis assumedto be at 4% insteadof6%, and thedividendyieldis assumedto be 6%
insteadof4%. Withthedividendyieldexceedingtherisk-free
rate,theconvenience
yield
in an equilibrium
on thefutures
exceedsthecarrying
costresulting
futures
price(1243.85)
thatis lessthanthespot(1250).As shownintheexhibit,
theS&P 500 futures
pricesareless
thanthecorresponding
The binomialpriceofthe
spotpricesatall nodespriorto maturity.
Americanfutures
call (76.76in the3-periodexample)is lessthantheAmericanspotcall
(77.23),and the Americanfuturesput price (82.80 in the 3-periodcase) exceeds the
Americanspotputprice(82.62).It shouldbe notedthatthedifference
betweenAmerican
futures
contract
optionsandAmericanspotoptionsholdsforbothcasesinwhichthefutures
and optionexpireat thesametime.
expireslaterthantheoptionandwhenthefutures
CONCLUSION
Whilethederivation
oftheBOPM fora spotoptionhas becomea standardin most
derivativetexts,the derivationhas not been extendedto futuresoptions.Given the
offutures
andpractical
valueofthebinomialmodel,
popularity
optionsandthepedagogical
thispaper has presenteda derivationof the BOPM forfuturesoptions.As with all
theunderlying
economicprinciple
thevaluationofa derivative
isthe
derivatives,
governing
lawofoneprice.In thecaseoffutures
thisprinciple
existsbecausefutures
contracts
options,
can be replicated
witha spotpositiondefinedby thecarrying-cost
modeland becausean
in
on
the
futures
contracts
can
be
a
the
futures
contract
anda
option
replicated
by position
debt(orrisk-free
oftheBOPM forfutures
investment)
position.The derivation
options,in
relations
to
determine
the
turn,showshow thesearbitrage
equilibrium
priceof
converge
Fall 2008
79
BinomialPricingof
IndexFuturesand SpotOptionsforan InvertedFuturesMarket
= 90 Days
80
rate
futures
thebinomialderivation
also highlights
how therisk-free
options.In addition,
for
out
of
the
futures
but
not
the
how
the
exercise
futures
drops
options
spot,
early
advantage
is normalorinverted,
andhowtheupward
market
optionsdependson whetherthefutures
in termsofthemeanandvariability
can be estimated
ofeither
anddownwardparameters
spotorfutures
prices.5
ENDNOTES
1
In commodity
betweenthefutures
therelationship
futures,
price(f)andspotprice,as
definedbythecarrying-cost
model,is:
f0
DT
S0rnf + Knf + TRC
where:K = storagecostsperperiodforholdingtheunderlying
asset;TRC = transportation
assetfromthestoragefacility
tothedestination
costoftransporting
theunderlying
pointon
futures
contract
orviceversaat expiration
In thecaseofcommodity
futures
options,theequilibrium
optionpriceEquation(10)
includesa storagecost-adjustment
factor:
[C"-C,'1KandtP"-P?]K
S0r
S0r
a storagecost);forputs,
Forcalloptions,theadjustment
is positivegivenCu> Cd(implying
a negativestoragecostora shortposition
theadjustment
is negativegivenPu< Pd(implying
in the commodity).
In cases in which shortingthe commodityis not applicable,the
is
not
definable.
factor
adjustment
2
assetyields,seeHull(2006):112Fora discussion
ofadjusting
equationp forcontinuous
113and256.
The Blackfutures
model(1976)is
C;=[foN(d,)-XN(d2)]e-E'T
P[X(1J
N(d2 ))
f0(l
N(d,))]e~RfT
ln(f0 / X) + (<Tf / 2)T

<TfVt
- o a/
d2 = d
f
2
2
return
of futures
where:af2 = varianceof thelogarithmic
prices= V(ln(/f0);
of = as
T = timetoexpiration
as a proportion
ofspotpriceslogarithmic
return);
expressed
(volatility
81
Fall 2008
ofa year;Rf= continuously

rate.UsingtheBlackmodel,the
compoundedannualrisk-free
the
of
futures
call
is
77.06
and
the
of
the
futures
price
option
price
putis 68.91.The Black
OPM callpriceof77.06is$0.02greater
thanthe30-period
Europeanbinomialvalueof77.04
andtheBlackputvalueof68.94is0.03greater
thanthe30-periodEuropeanbinomialvalue
of68.91. NotethattheAmericanbinomialvalueofthecallis77.30andthevalueoftheput
is69.11, implying
inusingtheBlackmodeltopriceAmericanfutures
errors
pricing
options.
Interested
readerswho wouldlikea copyoftheExcelprogram
usedto calculatethe
binomialvaluesoftheAmericanand Europeanfutures
andspotoptionsshownin Exhibits
3-5 can emailtheauthorsat johnsons@xavier.edu
or razuber@imcc.edu.
SELECTED REFERENCES
Black,F., and M. Scholes."ThePricingof Optionsand CorporateLiabilities."
Journalof
PoliticalEconomy%' (May-June1973),637-59.
ofFinancialEconomics,
3 (March
Black,F. "ThePricingofCommodity
Contracts,"
Journal
167-79.
1976),
and M. Subrahmanyam.
Brenner,
M., G. Courtadon,
"Optionson theSpotand Optionson
Futures."TheJournal
ofFinanceAO(December1985),1303-17.
toDerivatives
andRiskManagement
Chance,D. and R. Brooks.An Introduction
(Mason,
7th
Thomson
South-Western.
OH, 2007), Edition,
Cox,JohnC, S. Ross,andM. Rubinstein.
Journal
"OptionPricing:A Simplified
Approach."
ofFinancialEconomicsl (September
1979),229-63.
Futuresand OptionsunderStochastic
Hilliard,J.E., and J.Reis."ValuationofCommodity
ConvenienceYields,InterestRates,and JumpDiffusions
in the Spot,"Journalof
Financialand Quantitative
1
61-86.
33, (March1998),
Analysis,
,andOtherDerivatives
Hull,J.C.Option,Futures
Edition,
(UpperSaddleRiver,NJ,2006),6th
PrenticeHall.
Kolb,R. and J.Overdahl.Futures
, Options
, and Swaps(Maiden,MA, 2007), 5thEdition,
BlackwellPublishing.
andB.J.Bartter.
"Two-State
ofFinance,34 (1979),
Rendleman,
R.J.,
Journal
OptionPricing,"
1093-1110.
A Comparison
ofEuropeanand
Shastri,
K.,and K. Tandon."Optionson FuturesContracts:
AmericanPricingModels."TheJournalofFuturesMarkets6 (Winter1986),593-618.
ForwardContracts."
Science29 (October
Thorp,E. "Optionson Commodity
Management
1985),1232-42.
Whaley,R. "ValuationofAmericanFuturesOptions:Theoryand Tests."TheJournalof
Finance41 (March1986),127-50.
ofCommodity
ofFuturesMarkets!
Wolf,A. "Fundamentals
Journal
Optionson Futures."
(1982),391-408.
Wolf,A., and L. Pohlman."Testsof the Blackand WhaleyModelsforGold and Silver
FuturesOptions."TheReviewofFuturesMarkets6 (1987),328-47.
82
APPENDIX A: ALGEBRAICDERIVATION OF EQUATION (10)

C = -[pC +(1 - p)C ] and P = -[pP
r
r
+(l-
p)P]
Given:
fu-fd = (uS0rnf~'-Dt)
(dS0rnf-'-DT)
f Dt)
fu f0 = (uS0r
(S0r
f fd f0 = (dS0r
Dt)
(S0r
ff-
= S0rnf
Lr
f
DT) = S0r
f
DT) = S0r
Lr
1
J
Lr
1
J
rJ
Substitutinginto Equation (5):

r*_
0-
Cu(fd-f0)-Cd(fu-f0)
nX
r (fu ~fd)
0~
P)
Cu[S0rnf _l]_Cd[S0rnf~- il]

r
Lr J
L
J
r
7
_
0 ~~
Lr
rJ
CuS0rnf|~1-- + CdS0rnfI"- l
r
|_r
J ~_
L
J
~_
+ cj--l]
S0rnf[cjl--
|_r J
L rj
rSornf[-u_dl
Lr rJ
S0rnf[u-d]
+
cil--]
cd[--ll
L rJ
Lr J
i^]
c; = - t
+ Cdr--ii
MI
[.ii
^
^ - J = cu
r-L cdû-d
u-d
u-d
c*0 -~ ifc uriî.cj

r
Lu-dJ
r- ,il
Lu-dJ
c; = -[pcu+(i-p)cd]
r
where:
p=
r-d
,
and
u-d
, - = u-d
1 p
u-d
r-d
u-r
=
u-d
u-d
Forfuturesputoption: Pj = -|ppu+(i-p)pd]
r
83
Fall 2008
AppendixB: BOPM DEFINED IN TERMS OF THE

FUTURESPRICES' UP AND DOWN PARAMETERS
The formulas
forestimating
u and d are foundby solvingfortheu and d valuesthat
maketheexpectedvalueand thevarianceofthebinomialdistribution
ofthelogarithmic
returnof the underlying
pricesequal to theirrespectiveestimatedparameter
security's
ofan equal probability
ofthesecurity
in
values,j and cr,undertheassumption
increasing
one period(or equivalently
thatthe distribution
of logarithmic
returnis normal). The
formula
valuesforu and d thatsatisfy
thisconditionare:
' At+ ^
u= e s
a - e
where:
annualizedstandarddeviationofthespotprices logarithmic
return
as = estimated
=
estimated
annualized
mean
of
the
return
spotprice'slogarithmic
'i$A
At= thelengthofthebinomialperiod= t/n,where:t = timeto expiration
as a
ofa yearand n = numberofperiodsto theoption'sexpiration
proportion
As noted,it is commonto also definetheup and down parameters

in termsof the
futures
uf
if
modelholds,thenufand dfare
prices, and df. Specifically,thecarrying-cost
givenas:
p(RA-V)(nf"l)^
u
f _ f _ 11^
u:>0e
f0
S0e(RA"v)MfAl e(RA-v)At
CB-1)
d
df_fd_dS0e(RA-,|r)(nf-1)t_
fo
S0e(RA-v)nfil e(RA-V)At
d = dfe(RA~Ât
(B
2)
The formulas
forestimating
theup anddownparameters
as definedin termsofthefutures
and
are:
(uf
d*)
price
^
yf _ gaf
df _ e-o*
+'JfAt
_
VB +M.Ât
-K(l^-(RA-l|)At
(B _ 3)
+(tiA-(RA-v)At
_ 4)
where:
A
A
deviationand meanon thefutures
prices
CTfand if = annualizedstandard
return
logarithmic
84
The relationships
betweenthevolatility
and meanon thefutures
price'slogarithmic
returnand thespot'svolatility
and mean,in turn,are:
(B-5)
(B - 6)
f=asA
= nsA- (Ra -v)
The algebraicderivation
in theTable B.l.
ofEquations(B-5) and (B-6) is presented
and
into
the
for
we
(B-2)
Equations(B-l)
equation p, obtainthe equations
Substituting
forthefutures
callandputoptionsdefinedintermsofthefutures
up anddownparameters:
c(RA-,jtt_d
u-d
P
f
P ~
and
e(RA-V)Ai_ dfe(RA-V)At
ufe(R~v)Ai-dfe(RA_)At
1- df
uf - df
C = - At[pfcu+(l-pf)Cd]
e-R
po = ^-[pfPu+a-pf)Pd]
gR At
Thepftermis therisk-neutral
definedin termsoftheup anddownparameters
probability
forthefutures
priceinsteadofthespotprice.
f
f
f
As noted,since u and d includethe risk-free
rate and the dividendyield,p is
determined
atleastfordiscrete
casesinwhichtherearea smallnumber
bybothparameters,
In a multiple-period
ofperiodsto expiration.
increases
model,as thenumberofsubperiods
orequivalently
as thelengthofthebinomialperiodAt(= t/n)becomessmaller,
thesecond
termintheexponent
ofEquations(B-3)and(B-4)- a termthatincludesnotonlythemean,
butalso therisk-free
rateand dividendyield- goes to zero fasterthanthe squareroot
terms.As a result,
fora largenumberofsubperiods,
theequationsforufand dfsimplify
to:
u
f =
e ^
df = e^
= u
=d
f f
f
andtherefore
all threeterms- p,u and d -are absentoftherisk-free
rateanddividend
for
the
case
of
the
that
needs
to
be
estimated
todetermine
the
Thus,
n,
yield.
large
onlyinput
of
an
on
a
futures
is
the
futures'
financial
contract
price
option
spotvariability
underlying
"asFall 2008
85
Table B.l: Algebraic Derivation Of p*,uf,and df

u
e(RA-<|>)At
+^
e^
+
cj^Vt uÂt
e(RA-^)At
4.^5
'
Vee(RA-|>)At
/
CT^Vt+ |iAAt=aAVt + |iAAt

- (RA
-i>)At
A o-Jl+ HgAt (RA i>)At-iÂt
(1)
df =-
e(RA-*)At
e^t+Ât
eWt+HfAAt
e(^)At
-a^/t
a
f~
HÂt
c^Vt
Ve
JÂt
-o-Jt
HÂt
+ |iAAt- (RA - i>)At
+ (RA -i>)At+
jÂt
~
V5
(2)
86
Table B.l (continued)
forah and i^:

SolvingEquations(1) and (2) simultaneously
Equation(1):
crAVt = o-AVt + |jAAt- (RA -i>)At- |jAAt
(3)
Equation(2) expressedin termsof |jAfAt:

|jAAt=-aAVt
+ |jAAt- (RA -iOAt+ CT^^/t"
(4)
(4) into(3) and solvingfor(Jf^:

Substituting
oAVt = aAV t + |jAAt- (RA -i;)At
+ crAVt - jAAt+ (RA -i>)At
of
(5)
crsA
forcnAin Equation(4) and solvingin termsof |JfA
:
Substituting
fiAAt= -a^Vt
+ iÂt- (RA -'))At+ <jyft~

(6)
rf=-[-(RA-<i>m
Given:
u = ufe(RA-Ât and d = dfe(RA-Ât
into equationforp:
Substituting
P~
e(RA->)At_dfe(RA-4>)At
uf
~ j_df ~ _f
P
- df e(RA-^)At uf -df
Fall 2008
87

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The Binomial Pricing of Options on Futures Contracts

R. StaffordJohnson,Richard A. Zuber and JohnM. Gandar

oftheBinomialOptionPricingModel (BOPM) byCox,Rossand

in additionto itspedagogicalvalue,thediscretebinomialmodelis themostwidelyused

Journal of Financial Education

examplesof the binomialpricingof Americanand Europeanoptionson an S&P 500

Giventhe two possiblespotprices(Su = uS0and Sd= dS0),thetwo possiblefutures

The possiblepricesofthe call and put optionon the futurescontractwithan exercise

Journalof Financial Education

Giventhepossiblepriceson thefuturescontractand futuresoptionsat the end of

RPp =Hg(fd -f0) + rl0

Note,thefuturescontracthas no initialvalue (Vf0= 0).

Journal of Financial Education

Givenfd< f0,10 and P0 are therefore

PointsOn BOPM For FuturesOptions

Journal of Financial Education

= annualizedstandarddeviationand meanon thefuturesprice's

dividendyield,p (Equation(13)) is determined

Journal of Financial Education

Exhibit1. BinomialPricingofIndexFuturesCall and Put Options

Journalof Financial Education

example,the equilibriumprice of a Europeancall optionon the spot indexwith an

125.]+ (.3333Max[1187.5- 1250,0]]

Journal of Financial Education

^ = 1431.25,Pu= 0 fd= 1234.375,Cd= 5.625

Usingthe single-periodBOPM, the equilibriumpriceof the call optionon the index

Ifthemarketpriceofthefuturescall optiondoes notequal itsequilibriumvalue,then

Exhibit2. BinomialPricingofIndexFuturesCall and Put Options

Journalof Financial Education

MULTIPLE-PERIOD BOPM FOR FUTURES OPTIONS

The BOPM can be adjustedto valueAmericanoptions(Ca0and Pa0)bydetermining

Journal of Financial Education

and also thepresenceofan earlyexercise

Journalof Financial Education

fortheAmericanspotput.The Americanfutureputprice,though,is stillless thanthe

Journalof Financial Education

ln(f0 / X) + (<Tf / 2)T

ofa year;Rf= continuously

Journal of Financial Education

APPENDIX A: ALGEBRAICDERIVATION OF EQUATION (10)

Substitutinginto Equation (5):

Cu[S0rnf _l]_Cd[S0rnf~- il]

c*0 -~ ifc uri^i.cj

AppendixB: BOPM DEFINED IN TERMS OF THE

As noted,it is commonto also definetheup and down parameters

Journal of Financial Education

Table B.l: Algebraic Derivation Of p*,uf,and df

CT^Vt+ |iAAt=aAVt + |iAAt

+ |iAAt- (RA - i>)At

Journalof Financial Education

Table B.l (continued)

forah and i^:

Equation(2) expressedin termsof |jAfAt:

+ |jAAt- (RA -iOAt+ CT^^/t"

(4) into(3) and solvingfor(Jf^:

+ i^At- (RA -'))At+ <jyft~

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