Chapter 22, 25

Options, Futures and Forwards

 An option gives the holder the right, but not the obligation,
to buy or sell a given quantity of an asset on (or before) a
given date, at prices agreed upon today.
 Exercising the Option
◦ The act of buying or selling the underlying asset
 Strike Price or Exercise Price
◦ Refers to the fixed price in the option contract at which the holder can
buy or sell the underlying asset
 Expiry (Expiration Date)
◦ The maturity date of the option

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22-1
 European versus American options
◦ European options can be exercised only at expiry.
◦ American options can be exercised at any time up to expiry.
 In-the-Money
◦ Exercising the option would result in a positive payoff.
 At-the-Money
◦ Exercising the option would result in a zero payoff (i.e., exercise price
equal to spot price).
 Out-of-the-Money
◦ Exercising the option would result in a negative payoff.

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22-2
 Call options gives the holder the right, but not the
obligation, to buy a given quantity of some asset
on or before some time in the future, at prices
agreed upon today.
 When exercising a call option, you “call in” the
asset.

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22-3
 At expiry, an American call option is worth the same as
a European option with the same characteristics.
◦ If the call is in-the-money, it is worth ST – E.
◦ If the call is out-of-the-money, it is worthless:
C = Max[ST – E, 0]
Where
ST is the value of the stock at expiry (time T)
E is the exercise price.
C is the value of the call option at expiry

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 60
Option payoffs ($)

40

20

20 40 60 80 100 120
50
Stock price ($)
–20

–40 Exercise price = $50

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22-5
 60
Option profits ($)

40 Buy a call

20
10

20 40 50 60 80 100 120
–10 Stock price ($)
–20

Exercise price = $50; option premium = $10

–40

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22-6
 Put options gives the holder the right, but not the
obligation, to sell a given quantity of an asset on
or before some time in the future, at prices agreed
upon today.
 When exercising a put, you “put” the asset to
someone.

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22-7
 At expiry, an American put option is worth the
same as a European option with the same
characteristics.
 If the put is in-the-money, it is worth E – ST.
 If the put is out-of-the-money, it is worthless.
P = Max[E – ST, 0]

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22-8
 60
Option payoffs ($)

50
40

20

0 Buy a put
0 20 40 60 80 100
50
Stock price ($)
–20

–40
Exercise price = $50
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22-9
 60
Option profits ($)

40

20

10
Stock price ($)
20 40 50 60 80 100
–10
Buy a put
–20

–40 Exercise price = $50; option premium = $10

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22-10
 Intrinsic Value
◦ Call: Max[ST – E, 0]
◦ Put: Max[E – ST , 0]
 Speculative Value
◦ The difference between the option premium and the
intrinsic value of the option.

Option Intrinsic + Speculative

=
Premium Value Value

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22-11
 A forward contract specifies that a certain commodity
will be exchanged at a specified time in the future at a
price specified today.
◦ Its not an option: both parties are expected to hold up their
end of the deal.
◦ If you have ever ordered a textbook that was not in stock, you
have entered into a forward contract.

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22-12
 A futures contract is like a forward contract:
◦ It specifies that a certain commodity will be exchanged at a
specified time in the future at a price specified today.

 A futures contract is different from a forward:

◦ Futures are standardized contracts trading on organized
exchanges with daily resettlement (“marking to market”)
through a clearinghouse.

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22-13
 Standardizing Features
◦ Contract Size
◦ Delivery Month
 Daily resettlement
◦ Minimizes the chance of default
 Initial Margin
◦ About 4-10% of contract value
◦ Cash or T-bills held in a street name at your
brokerage

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22-14
Suppose you want to speculate on a rise in the $/¥
exchange rate (specifically, you think that the dollar will
appreciate).
Currency per
U.S. $ equivalent U.S. $
Wed Tue Wed Tue
Japan (yen) 0.007142857 0.007194245 140 139
1-month forward 0.006993007 0.007042254 143 142
3-months forward 0.006666667 0.006711409 150 149
6-months forward 0.00625 0.006289308 160 159

Currently $1 = ¥140.
The 3-month forward price is $1=¥150.
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 Currently $1 = ¥140, and it appears that the dollar is
strengthening.
 If you enter into a 3-month futures contract to sell ¥
at the rate of $1 = ¥150 you will profit if the yen
depreciates. The contract size is ¥12,500,000
 Your initial margin is 4% of the contract value:

$1
$3,333.33 = 0.04 × ¥12,500,000 ×
¥150

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22-16
If tomorrow the futures rate closes at $1 = ¥149, then
your position’s value drops (¥ appreciated).
Your original agreement was to sell ¥12,500,000 and
receive $83,333.33:

$83,333.33 = ¥12,500,000 × $1
¥150
But, ¥12,500,000 is now worth $83,892.62:
$1
$83,892.62 = ¥12,500,000 ×
¥149
You have lost $559.29 overnight.
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 The $559.29 comes out of your $3,333.33 margin
account, leaving $2,774.04.
 This is short of the $3,355.70 required for a new
position.
$1
$3,355.70 = 0.04 × ¥12,500,000 ×
¥149
Your broker will let you slide until you run through
your maintenance margin. Then you must post
additional funds, or your position will be closed out.
This is usually done with a reversing trade.
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22-18
 The CME Group is by far the largest, consolidating:
◦ Chicago Board of Trade
◦ Chicago Mercantile Exchange
◦ New York Mercantile Exchange

 Others include:
◦ The London International Financial Futures Exchange

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