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Options On Futures
Options On Futures
Options on Futures
Chapter 13 1
Characteristics of Options on Physicals
and Options Futures
Recall from Chapter 12 that options are written for a pre-
specified amount of a pre-specified asset at a pre-specified
price that can be bought or sold at a pre-specified time
period.
Call Options
The buyer of a call option has the right but not the
obligation to purchase.
Put Options.
The buyer of a put option has the right but not the
obligation to sell.
Chapter 13 2
Characteristics of Options on Physicals
and Options Futures
Chapter 13 3
Characteristics of Options on Physicals
and Options Futures
– Receives a payment = F0 – E
– Pay $5,000.
Chapter 13 4
Characteristics of Options on Physicals
and Options Futures
The put owner would not exercise unless the exercise price
exceeded the futures settlement price.
Chapter 13 5
Characteristics of Options on Physicals
and Options Futures
– Receives a payment = F0 – E
– Pays $400.
Chapter 13 6
Characteristics of Options on Physicals
and Options Futures
Chapter 13 7
The Market of Options on Futures
Chapter 13 8
The Market of Options on Futures
Table 13.1
Trading Volume for Futures Options
(Year Ending September 30, 2003)
Commodity Group Number of Contracts Traded (millions)
Grain 6.8
Oilseeds 5.3
Livestock 0.9
Other Agricultural 5.3
Energy/Wood 20.7
Metals 4.3
Financial Instruments 173.9
Currencies 2.1
Total 219.2
Chapter 13 9
The Market of Options on Futures
Chapter 13 10
The Market of Options on Futures
Chapter 13 11
The Market of Options on Futures
Chapter 13 12
Pricing Options on Futures
European Options
American Options
Chapter 13 13
Graphical Approach to American
Options on Futures
Chapter 13 14
Black-Scholes Model for Options on
Forward Contracts
- rt
C=e [ F 0,t N( d *1 ) - E N( d *2 )]
Where
r = risk-free rate of interest
t = time until expiration for the forward and the option
F0,t = forward price for a contract expiring at time t
α = standard deviation of the forward contract’s price
ln( F / E ) .5 2 t
d *
1
t
d * 2 d *1 t
If there were no uncertainty, N(d1*) and N(d2*) will equal
1 and the equation would simplify to:
Cf = e-rt[F0,t - E]
Chapter 13 15
European Versus American Option on
Futures
European Options
Early exercise of an option on a non-dividend paying stock
is not recommended:
– Recall that upon exercising, the call owner receives the
intrinsic value (S – E).
– Exercising a call discards the excess value of the option
over and above S – E.
American Options
Early exercise of a dividend paying futures option has
benefits and costs
– Benefit: exercise provides an immediate payment of F – E
which can earn interest until expiration ert [F - E].
– Cost: sacrifice of option value over and above intrinsic
value F – E.
Chapter 13 16
Approximating European and American
Futures Option Values
Tab le 13.2
Co mp ariso n o f Euro p e an and Ap p ro ximate Ame rican
Futures O p tio n Call Value s
r = .08 σ = .20
t = .5 years E = 100
Approximate
Futures Price European American
80 0.30 0.30
90 1.70 1.72
100 5.42 5.48
110 11.73 11.90
120 19.91 20.34
Source: G. BaroneBAdesi and R. Whaley, AEfficient Analytic Approximation of
American Option Values,@ Journal of Finance, 42:2, June 1987, pp. 301B320.
Chapter 13 17
Efficiency of The Option on Futures
Market
Most tests of efficiency examine whether market prices
match the prices of a theoretical model.
A test of market prices against a theoretical model is a joint
test of the market's efficiency and the model's ability to
correctly represent the price.
The results of Whaley’s test for efficiency are presented in
Table 13.3.
Table 13.3
Pricing Discrepancies for S&P 500 Futures Options
Observed Market Price C Theoretical Price
Summary of average pricing errors of American futures option pricing models by the option's moneyness
(F/E) and by the option's time to expiration in weeks (t) for S&P 500 futures option transactions during the
period January 28, 1983, through December 30, 1983.
Calls Puts
t<6 6 t < 12 t 12 All t t<6 6 t < 12 t 12 All t
F/E < 0.98 B0.0630 B0.1372 B0.0872 B0.1028 B0.1064 B0.0914 B0.1056 B0.1014
0.98 F/E <1.02 B0.1228 B0.0775 0.0073 B0.0924 B0.0816 B0.0196 0.1336 B0.0406
F/E 1.02 0.0577 0.1175 0.0702 0.0806 0.1286 0.1906 30.3060 0.1929
All F/E B0.0757 B0.0599 B0.0120 B0.0606 B0.0191 0.0808 0.2287 0.0537
Source: R. Whaley, AValuation of American Futures Options: Theory and Empirical Tests,@ Journal of
Finance, March 1986, p. 138.
Chapter 13 18
Efficiency of The Option on Futures
Market
Table 13.4
Tests of Efficiency for Futures Options
Study Key Results
Whaley (1986) For S&P 500 futures options, market and theoretical
prices are systematically different.
Jordan, McCabe, and For soybeans, compared the difference between actual
Kenyon (1987) market prices and the Black model price, with average
differences being 4/100 of a cent per bushel.
Wilson and Fung For grain futures options, prices closely conformed to
(1988) the Black model. In periods of high volatility, actual
prices did not rise as much as Black model prices.
Chapter 13 19
Price Relationship Between Options on
Physicals and Options on Futures
1. European options
Chapter 13 20
Price Relationship Between Options on
Physicals and Options on Futures
Chapter 13 21
European Options on Physicals and
Futures
S-E
Ft,t - E = St - E
Chapter 13 22
American Options on Physicals and
Futures with No Underlying Cash Flows
Tab le 1 3 .5
Pe rce nt ag e Diffe re nce in Value
fo r Call O p t io ns o n Future s and O p tio ns o n Phy sicals
Assumptions:
Chapter 13 23
American Options on Physicals and
Futures with Underlying Cash Flows
These cash flows affect both the option on the physical and
the option on the futures.
F0,t – E, t = 0
F0,t = S0(1 + C)
Chapter 13 24
American Options on Physicals and
Futures with Underlying Cash Flows
C f = e rt [ S 0 N( d *1 ) EN( d *2 )]
where:
Cf = the price of a call option on the futures
C f = e-rt S 0 N( d 1 ) - EN( d 2 )
The values for the call option on the futures and physical are
the same. That is, d1* = d1, and d2* = d2.
Chapter 13 25
Relative Prices of Options on Physicals
and Futures
where:
Cf, Cp = call on the futures and call on the physical
Pf, Pp = put on the futures and put on the physical
Chapter 13 26
Put-Call Parity for Options on Futures
C - P = S0 - Ee-rt
where:
Chapter 13 27
Put-Call Parity for Options on Futures
Cf - Pf = (F0,t - E)e-rt
where:
r = risk-free rate
Chapter 13 28
Put-Call Parity for Options on Futures
F0,t = S0ert
Substituting this expression for the futures price into the
above equation gives:
Chapter 13 29
Options on Futures and Synthetic
Futures
Synthetic Futures
Chapter 13 30
Risk Management with Options on
Futures
Chapter 13 31
Risk Management with Options on
Futures Example
Chapter 13 32
Risk Management with Options on
Futures
Chapter 13 33
Portfolio Insurance
Chapter 13 34
Synthetic Portfolio Insurance and Put-
Call Parity
From Figure 13.4, the Put + Index portfolio has the same
profits and losses as a call option with an exercise price of
$100.
where:
Chapter 13 35
Synthetic Portfolio Insurance and Put-
Call Parity
Chapter 13 36
Risk’s Return on Insured Portfolios
Portfolio A = Index
Portfolio B = Index + MAX{0, .5(100.00 - Index)}
Portfolio C = Index + MAX{0, 100.00 - Index}
Chapter 13 37
Risk Return in Insured Portfolios
Table 13.7
Probability That the Terminal Portfolio Value
W ill Be Equal to or Less than a Specified Value
Probabilities
Uninsured HalfBInsured Fully Insured
Terminal Portfolio Value Portfolio A Portfolio B Portfolio C
50.00 0.0014 0.0000 0.0000
60.00 0.0062 0.0000 0.0000
70.00 0.0228 0.0002 0.0000
80.00 0.0668 0.0062 0.0000
90.00 0.1587 0.0668 0.0000
100.00 0.3085 0.3085 0.3085
110.00 0.5000 0.5000 0.5000
120.00 0.6915 0.6915 0.6915
130.00 0.8413 0.8413 0.8413
140.00 0.9332 0.9332 0.9332
150.00 0.9773 0.9773 0.9773
160.00 0.9938 0.9938 0.9938
170.00 0.9987 0.9987 0.9987
Chapter 13 38
Risk Return in Insured Portfolios
Chapter 13 39
Risk Return in Insured Portfolios
Chapter 13 41
Why Options on Futures
Chapter 13 42