Topic 7: Options and Futures

FIN 3702B
Investment Analysis and Portfolio Management
Arkodipta Sarkar
 2
Overview
• Introduction

• Options
– Definition
– Types of options
– Payoffs graphs
– Simple Option Strategies
– Put-Call parity
– Option Valuation

• Forwards and Futures

– Definition
– Pricing of Forward and Futures
– Investment Strategies with Forwards and Futures
 3
Overview
• Introduction

• Options
– Definition
– Types of options
– Payoffs graphs
– Simple Option Strategies
– Put-Call parity
– Option Valuation

• Forwards and Futures

– Definition
– Pricing of Forward and Futures
– Investment Strategies with Forwards and Futures
 4

Introduction
• A “Derivative Instrument” is one for which the ultimate payoff to the investor
depends directly on the value of another security or commodity.
– Basic Type I: Forwards & Futures
– Basic Type II: Options
– Extended Derivatives: Swap contract / Convertible Securities / Other Embedded Derivatives
(Call feature of a bond)

• Derivative Trading gained enormous popularity in recent decades.

– Academic theory advance: More practicable valuation models (e.g. Black-Scholes for option).
– Meet both the demand of the prudent to hedge and control risk and the desire of the
gamblers with its large leverage ratio.

• The underlying assets include agricultural commodities, energy and petroleum,

metals, currencies, common stocks and stock indexes, bonds, and even some
other derivatives (option on the futures).
 5
Overview
• Introduction

• Options
– Definition
– Types of options
– Payoffs graphs
– Simple Option Strategies
– Put-Call parity
– Option Valuation

• Forwards and Futures

– Definition
– Pricing of Forward and Futures
– Investment Strategies with Forwards and Futures
 6

Definition of Options
• Call option gives its holder the right to purchase an underlying asset for a
specified price (called exercise price or strike price) on or before some specified
date (called expiration date)
• Put option gives its holder the right to sell an underlying asset for a specified
price (called exercise price or strike price) on or before some specified date
(called expiration date)
• While the holder of the option has the right to purchase or sell, the writer of the
option has the obligation to take the other side of the transaction
• Writer of the call option has the obligation to sell (if holder wants to exercise
the option)
• Writer of the put option has the obligation to buy (if holder wants to exercise
the option)
 7

Money-ness of Options
• In the Money - exercise of the option would have a positive payoff.
– Call: Market price > Exercise price
– Put: Exercise price > Market price

• Out of the Money - exercise of the option would not have a positive
payoff.
– Call: Market price < Exercise price
– Put: Exercise price < Market price

• At the Money - Exercise price and Market price are equal.

 8

Types of Options
• American versus European
– American option can be exercised at any time before expiration or maturity.
– European option can only be exercised on the expiration or maturity date.
– Which one is more valuable?
• Options are usually traded at centralized exchanges. They are more
likely to be based on financial securities like stocks rather than
physical assets (commodities).
– Stock Options
– Index Options
– Futures Options
– Foreign Currency Options
– Interest Rate Options
 9

Payoffs and Profits at Expiration - Calls

• Notation
Stock Price = ST Exercise Price = X

• Payoff to Call Holder

(ST – X) if ST > X
0 if ST < X
• Profit to Call Holder
Payoff – Premium

• Payoff to Call Writer

– (ST – X) if ST > X
0 if ST < X
• Profit to Call Writer
Payoff + Premium
 10

Payoffs and Profits at Expiration – Call Holders

 11

Payoffs and Profits at Expiration – Call

Writers
 12

Payoffs and Profits at Expiration - Puts

• Notation
Stock Price = ST Exercise Price = X

• Payoff to Put Holder

0 if ST > X
(X – ST) if ST < X
• Profit to Put Holder
Payoff – Premium

• Payoff to Put Writer

0 if ST > X
– (X – ST) if ST < X
• Profit to Put Writer
Payoff + Premium
 13

Payoffs and Profits at Expiration – Put Holders

 14

Payoffs and Profits at Expiration – Put Writers

$100
ST
Price of Put

Profit

Payoff

$100
 15

Simple Option Strategies

• An unlimited variety of payoff patterns can be achieved by combining
puts and calls with various exercise prices.
– Protective Put
– Straddle
– Bull Spread
 16

Protective Put
• You invest in a stock but are unwilling to bear losses beyond a certain level.
• Invest in stock and purchase a put option on the stock.
 17
Protective Put
 Puts can be used as
insurance against stock
price declines.
 Protective puts lock in a
minimum portfolio value.
X

 The cost of the insurance

is the put premium.
 Options can be used for
risk management, not
just for speculation.
 18

Straddle

• Long straddle: Buy call and put with same exercise price and maturity.
 19

Straddle
 The straddle is a bet on volatility.
 To make a profit, the change in stock
price must exceed the cost of both
options.
 You need a strong change in the stock
price in either direction.

 The writer of a straddle is betting that

the stock price will not change much.
 20

Bull Spread
• A spread is a combination of two or more calls (or two or more
puts) on the same stock with differing exercise prices (or differing
times to maturity).
• Some options are bought, whereas others are sold, or written.
• A bull spread is a way to profit from stock price increases.
• The payoff is the difference in the value of the call held and the
value of the call written.
 21

Bull Spread
• This strategy is called a bull
spread because the payoff
either increases or is
unaffected by stock price
increases.
• Holders of bull spreads benefit
from stock price increases.
 22

Put-Call Parity
①Protective put position
②Buy a call option and Treasury bills with a face value equal to the
exercise price

• These two payoffs are identical. Therefore, they must cost the same

• 𝑆0 + 𝑃0 = 𝐶0 + 𝑋𝑒 −𝑟𝑇
If the prices are not equal, arbitrage will be possible.
 Put Call Parity
• Investment 1: Protective Put
• Investment 2: Buy a call option on the same stock and Treasury bills with face value equal to
the exercise price
Payoff at Maturity
S<X S≥X
Protective Put (Stock + Put) X S
Call + T-bills X S

• Protective Put (Stock + Put)

– If S < X, exercise the put option and receive X (X – S + S)
– If S ≥ X, throw the put option away but have S

• Call + T-bills
– Receive X at maturity date (since X is the face value of the T-bills)
– If S < X, throw the call option away but receive face value X
– If S ≥ X, exercise the call option and receive face value X to get S (S – X + X)
23
 24

Option Value/Premium/Price
• Option Value = Intrinsic Value + Time
Value
• Intrinsic value – payoff that could be
made if the option was immediately
exercised.
– Call: Max {stock price - exercise price, 0}
– Put: Max {exercise price - stock price, 0}

• Time value (not the same

as time value of the money)
– difference between
the option price and the
intrinsic value. Most of the
time value is “volatility
value”.
 25

Binomial Tree: Option Pricing

We begin understanding option valuation by considering a simple case – a stock price
can take only two possible values at option expiration: The stock will either increase to
a given higher price or decrease to a given lower price.

120 10

100 C

90 0

Call Option Value

Stock Price
X = 110
 26

Binomial Tree: Option Pricing

Value the Call Option via an Alternative Portfolio

Buy 1 share of stock at $100
30
Borrow $81.82
(10% Interest Rate) 18.18
Net outlay $18.18
0
Payoff
Value of Stock 90 120 Payoff Structure
Repay loan - 90 - 90 is exactly 3 times
Net Payoff 0 30 the Call

Hence 3C = $18.18 or C = $6.06

 27

Binomial Tree: Option Pricing

 Another Alternative Portfolio:
 One share of stock and 3 calls written (X = 110)

 Portfolio is perfectly hedged:

Stock Value 90 120
Call Obligation 0 -30
Net payoff 90 90

 Given interest rate of 10%, the PV of the guaranteed payoff

90
= = 81.82.
1.1

 Hence:
 100 – 3C = $81.82
 3C = $18.18 or C = $6.06
 28

What is the Hedge Ratio?

• Generally, the hedge ratio is:
range of call values Cu  C d
H 
range of stock values uS0  dS0

• If the investor writes one option and holds H shares of stock, the value of
the portfolio will be unaffected by the stock price.

• In this case, option pricing is easy: Simply equate the value of the hedged
portfolio to the present value of the known payoff.
 29

What is the Hedge Ratio?

• Using our example, the option-pricing technique would be as follows:
– Given the possible end-of-year stock prices, uS0 = 120 and dS0 = 90, and the
exercise price of 110, calculate that Cu = 10 and Cd = 0. The stock price range
is 30, while the option price range is 10.
10 1
– Find that the hedge ratio of = .
30 3
1
– Find that a portfolio made up of share with one written option would have
3
an end-of-year value of $30 with certainty.
– Show that the present value of $30 with a 1-year interest rate of 10% is
$27.27.
– Set the value of the hedged position to the present value of the certain
payoff:
1
S – C0 = $27.27
3 0
$33.33 – C0 = $27.27
– Solve for the call’s value, C0 = $6.06.
 30

Expanding to 3 periods:
Assume that we can break the year into three intervals. For each
interval, the stock could increase by 20% or decrease by 10%.

Assume the stock is initially selling at $100.

S+++
S++ $172.80
$144
S+ S++-
$120 $129.60
S S+-
$108
$100 S+--
S- $97.20
$90 S--
$81 S---
$72.90
 31

Possible Outcomes:
Event Probability Final Stock Price
3 up 1/8 100 (1.20)3 = $172.80
2 up 1 down 3/8 100 (1.20)2 (.90) = $129.60
1 up 2 down 3/8 100 (1.20) (.90)2 = $97.20
3 down 1/8 100 (.90)3 = $72.90
 The extreme events such as u3S0 or d3S0 are relatively rare, as they require either three
consecutive increases or decreases in the three subintervals.
 More moderate, or mid-range, results such as u2dS0 can be arrived at by more than
one path—any combination of two price increases and one decrease will result in
stock price u2dS0. There are three of these paths: uud, udu, duu. In contrast, only one
path, uuu, results in a stock price of u3S0. Thus midrange values are more likely.
 As we make the model more realistic and break up the option maturity into more and
more sub-periods, the probability distribution for the final stock price begins to
resemble the familiar bell-shaped curve with highly unlikely extreme outcomes and far
more likely midrange outcomes. The probability of each outcome is given by the
binomial probability distribution, and this multi-period approach to option pricing is
therefore called the binomial model.
 32

Possible Outcomes:
• Eventually, as we divide the option maturity into an ever-greater
number of subintervals, each node of the event tree would correspond
to an infinitesimally small time interval. The possible stock price
movement within that time interval would be correspondingly small. As
those many intervals pass, the end-of-period stock price would more
and more closely resemble a lognormal distribution.
• When the stock price distribution is actually lognormal, we can derive
an exact option-pricing formula.
• It turns out that such a formula can be derived if one is willing to make
just two more assumptions: that both the risk-free interest rate and
stock price volatility are constant over the life of the option.
 33

Black-Scholes Option Pricing Model

• Call Price
( )
C = S0 N d1 - Xe - rT N d 2 ( )
where
æS ö æ s2ö
ln ç 0 ÷ + ç r + ÷ T
èXø è 2 ø
d1 = and d 2 = d1 - s T
s T
C: Theoretical Call Price; S0: Underlying Stock Current Price;
X: Exercise Price of the option; T: Time to maturity;
r: Annualized continuously compounded rate of return of risk-free asset;
σ: standard deviation of annualized continuously compounded rate of return of stock

• Put Price

( )
P = Xe -rT éë1- N d2 ùû - S0 éë1- N d1 ùû ( )
• The hedge ratio of call option in B/S model is N(d1) and hedge
ratio of put option in B/S model is N(d1) – 1.
 34

Example 2: Pricing an Option

Option maturity = 60 days
Exercise price = $90
Current Stock price = $90
Standard Deviation of returns = 35%
1-year risk-free rate = 4%

Assume stock will not pay dividend in the next 60 days

 35

Example 2: Pricing an Option

æS ö æ s2 ö æ 90 ö æ 0.352 öæ 60 ö
ln ç 0 ÷ + ç r + ÷T ln ç ÷ + ç 0.04 + ÷ç ÷
èXø è 2 ø è 90 ø è 2 øè 365 ø
d1 = = = 0.117
s T æ 60 ö
0.35çç ÷
÷
è 365 ø

60
𝑑2 = 𝑑1 − 𝜎 𝑇 = 0.117 − 0.35 = −0.025
365
 36

𝑁 𝑑1
7
= 0.5438 + 0.5478 − 0.5438
10
= 0.5466
 37

𝑁 𝑑2
5
= 0.4920 − 0.4920 − 0.4880
10
= 0.49
 38

Example 2: Pricing an Option

60
−0.04
𝐶 = 90 0.5466 − 90𝑒 365 0.49 = $5.38
60
−0.04
𝑃 = 90𝑒 365 1 − 0.49 − 90(1 − 0.5466) = $4.79

To confirm Put-Call parity:

𝑆0 + 𝑃0 = 90 + 4.79 = $94.79
60
−0.04 365
𝐶0 + Tbill = 5.38 + 90𝑒 = 5.38 + 89.41 = $94.79
 39

Comparative Statistics
• When St
– C /P

• When X
– C /P

• When r
– C Present Value(–X) is smaller (better)
– P Present Value(+X) is smaller (worse)

• When σ
– C more opportunity for S to move in desired direction (up)
– P more opportunity for S to move in desired direction (down)

• When T
– C more chance for S to move in desired direction (up) and PV(–X) is less (better)
– P? more chance for S to move in desired direction (down) but PV(+X) is less (worse)*

* True for European put option where early exercise is not allowed. In the case of American put options, time to
expiration must increase value since one can always choose to exercise early if this is optimal; hence longer time to
expiration merely provides more opportunity for S to move in desired direction (down).
 40

3.1.1 Forwards
• Forward contracts are the right and full obligation to
conduct a transaction (buy or sell) involving another
security or commodity - the underlying asset - at a
predetermined date (maturity date) and at a
predetermined price (contract price)
– It can be contrasted with a spot contract which is an agreement
to buy or sell immediately
– This is a trade agreement between two counterparties. Buyer is
long, seller is short. Customized (flexible) contracts and private
transactions
– Counterparty risk: Subject to credit risk or default risk
– No money changes hands when contract is first negotiated and
it is settled at maturity
– Contracts are traded OTC (Over The Counter), and are not liquid.
It is costly to exit the contract before it matures
 41

3.1.2. Futures
• Futures contracts are similar to forward contract, but is
more actively traded and is subject to a daily settlement
process
– Standardized contracts: goods description, unit, maturity.
– The future price is, at any given time during the contract life, set
at a level such that a brand-new long or short position would not
have to pay a premium to enter the agreement.
– Traded on central markets (future exchanges) and backed by
clearinghouses
– The future exchanges require both counterparties to post
collateral (margin) to protect itself from default risk. The margin
value will be measured on a marked-to-market value.
– More liquidity – Investor can change hands easily before the
contract maturity.
 42

Exchange-traded Futures
• Sample of Futures contracts :
 43

3.1.3. Mechanics of Futures Contract

• Initialization, time = 0
– For a fixed quantity and quality of underlying security/product
– set a price today, F0,T , for settlement/delivery at fixed point in future (time
= T)
– security is worth today at spot price S0
– no money transacted today
– EMH => PV[F0,T] = PV [ST]

• Maturity, time = T
– long party obliged to pay F0,T
– short party obliged to deliver security
– security is now worth ST
– net worth to long party = ST – F0,T
net worth to short party = F0,T – ST

• Zero-sum game between long and short parties

 44

3.1.3. Mechanics of Futures Contract

• Marked-to-market for futures
– Exchange requirement: daily profit/loss settlement
– Day 1 long party gets F1,T – F0,T
– Day 2 long party gets F2,T – F1,T
– Day 3 long party gets F3,T – F2,T
– …
– Day T-1 long party gets FT-1,T – FT-2,T
– Day T long party gets ST – FT-1,T
– In total, long party gets ST – F0,T

• Similar to forwards but

– time value of money

• Profit/loss offsets from margin account

– when margin level drops to a threshold, margin call to top-up

• Minimize losses to clearinghouse when a party defaults

 45

Example 3: Margin & Daily Settlement

Contract Size = 500
Initial Margin = 15% = $2,550.00
Maintenance Margin = 10% = $1,700.00

Date Futures Price Daily G/L Cum. G/L Margin Bal. Margin Call
$34.00 $2,550.00
10-Aug $32.70 -$650.00 -$650.00 $1,900.00 $0.00
11-Aug $33.02 $160.00 -$490.00 $2,060.00 $0.00
12-Aug $32.16 -$430.00 -$920.00 $1,630.00 $920.00
13-Aug $32.78 $310.00 -$610.00 $2,860.00 $0.00
14-Aug $30.14 -$1,320.00 -$1,930.00 $1,540.00 $1,010.00
17-Aug $31.47 $665.00 -$1,265.00 $3,215.00 $0.00
18-Aug $33.18 $855.00 -$410.00 $4,070.00 $0.00

3.1.4. Forwards vs. Futures
Forwards
• Private contract between 2 parties
• Non-standard contract
• Usually 1 specified delivery date
• Settled at maturity
• Delivery or final cash
• Counterparty risk is higher
• Settlement usually occurs
46
Futures
• Exchange-traded
• Standard contract
• Range of delivery dates
• Settled daily: Marked to Market
• Contract usually closed out
• Clearinghouse warrants performance
• Usually settled prior to maturity
 47

3.2.1. Payoff of Forwards/Futures

 48

3.2.2. Forward Pricing

• Consider a forward contract on a security with price $100
(S0) that provides $2 dividend at year-end. The contract
matures in one year(T), the risk-free rate is 2% (r), and F0,T is
the forward price.
– Let’s form the following portfolio:
• Borrow $100 at the risk-free rate and buy one unit of the security
• Short one forward contract.

• The following will be the cash flows related to this portfolio:

t=0 t=T
Borrowing +100 −100 × (1 + 0.02)
Stock –100 +ST + 2
Short Forward 0 F0,T – ST
Total 0 F0,T + 2 −100 × (1 +
0.02)
Qn – What should F0,T be?
 49

3.2.2. Forward Pricing (cont’d)

• From the previous slide

– F0,T +2 − 100 × 1.02 = $0
– Otherwise, there will be an arbitrage opportunity
– F0,T = 100 × 1.02 − 2 = 𝑆0 × 1 + 𝑟 − 𝐷 = $100

• In general, the pricing formula for a forward contract

is:
𝐷
– F0,T = S0(1 + r – d)T, where d is
𝑆0
 50

3.3. Investment Strategies with

Forwards/Futures
Two types of investment strategies:

• Arbitrage when there is a mispricing

• Hedging
– Hedging Systematic Risk
– Hedging Interest Rate Risk
 51

3.3.1. Arbitrage with Forward

• Using the previous example, what is the arbitrage opportunity?
– What would you do if the forward price is $95?
– What if the forward price is $110?

• You can make a sure future profit without any investment today by
purchasing a cheaper one and selling an expensive one as is shown
below for each case.
f = $95 f = $110
t=0 t=T t=0 t=T
Long/Short forward 0 S T - $95 0 $110 - ST

Lend/
Short/Long -$100 +$100*(1.02)
+$100 +$100 -$100*(1.02)
−$100
Borrow × (1.02) × (1.02)
synthetic
forward Sell/Buy
+$100 -S T - 2 -$100 +S T + 2
security
Net 0 +$5 0 +$10
 52

3.3.2. Hedging with Forwards/Futures

What is hedging?
• Underlying position: Long position in market portfolio
• Risk: Need to offset when market falls
• Hedging requirement: What provides opposite profit/loss?
– Short position in market index futures

• Time 0: – S0
• Time T: ST + F0,T – ST = F0,T
• Totally hedged (final payoff is flat, i.e. independent
of ST)
 53

3.3.3. Hedging Systematic Risk

How might a portfolio manager use futures to hedge market exposure?
• To protect against a decline in stock prices, short the appropriate
number of futures index contracts.
– Less costly and quicker than liquidating
– Use the beta for the portfolio to determine the hedge ratio.
 54

Example 4: Hedging Systematic Risk

S&P 500 is at 1,000 but falls to 975
Decrease = 2.5%
Portfolio Value = $30 million, with beta of 0.8
Projected loss if market declines by 2.5% = (0.8) (2.5%) = 2%
Projected dollar loss = 2% of $30 million = $600,000

Given a contract multiplier of $250, each S&P500 index contract

will change by
1000 − 975 × $250 = $6,250 for a 2.5% change in the index

Q: What is the hedge ratio here?

 55

Example 4: Hedging Systematic Risk (cont’d)

Change in the portfolio value

H=
Profit on one futures contract

$600,000
= = 96 contracts (short)
$6,250

To hedge your risk, you would sell the index futures.

When your portfolio falls in value along with declines in the
market, the futures contract will provide an offsetting profit.
 56

3.3.4. Hedging Interest Rate Risk

• Fixed-income managers also sometimes desire to
hedge market risk, in this case resulting from
movements in the entire structure of interest rates.
– A fixed-income manager wants to protect considerable
capital gains in her portfolio from an increase in interest
rates but is reluctant to sell her portfolio and replace it with
a lower-duration mix of bonds because such rebalancing
would result in large trading costs as well as realization of
capital gains for tax purposes.
– Corporations planning to issue debt securities want to
protect against a rise in rates.
– A pension fund with large cash inflows may hedge against a
decline in rates for a planned future investment.
 57

Example 5: Hedging Interest Rate Risk

Portfolio value = $10 million
Modified duration = 9 years
If rates rise by 10 basis points (0.1%), then
Change in value ≈ −9 × 0.1% = −0.9% or -$90,000
$90,000
Price value of a basis point (PVBP) =
10
= $9,000 fall per basis point
Suppose each T-bond contract rewards $90 per basis point rise

Q: What is the hedge ratio?

 58

Example 5: Hedging Interest Rate Risk

(cont’d)
PVBP for the portfolio
H =
PVBP for the hedge vehicle

=
$9,000
= 100 T-Bond contracts
$90

• The T-bond contracts drive the interest rate exposure of a bond position to
zero (the portfolio’s exposure is offset).
• This is a market neutral strategy. Gains on the T-bond futures offset losses
on the bond portfolio.
• However, the hedge is imperfect in practice because of slippage – the yield
spread (between Corporate bonds and Treasuries) does not remain
constant.
 59

Readings and Assignment

• Readings:
– Chapter 20 (20.1, 20.2, 20.3, 20.4)
– Chapter 21 (21.1, 21.3, 21.4, 21.5)
– Chapter 22 (22.1, 22.2, 22.3, 22.4(the spot-futures parity theorem))
– Chapter 23 (23.2, 23.3)