Ch15 of Fundamentals of Financial Instruments

Options on Stock Indices
and Currencies
Chapter 15
Fundamentals of Futures and Options Markets, 7th Ed, Ch 15, Copyright © John C. Hull 2010 1
Index Options
 The most popular underlying indices in the U.S. are
 The S&P 100 Index (OEX and XEO)
 The S&P 500 Index (SPX)
 The Dow Jones Index times 0.01 (DJX)
 The Nasdaq 100 Index (NDX)
 Contracts are on 100 times index; they are settled in

cash; OEX is American; the XEO and all other
options are European.
Index Option Example
 Consider a call option on an index

with a strike price of 560
 Suppose 1 contract is exercised
when the index level is 580
 What is the payoff?
Using Index Options for Portfolio
Insurance
 Suppose the value of the index is S0 and the strike
price is K
 If a portfolio has a  of 1.0, the portfolio insurance is
obtained by buying 1 put option contract on the index
for each 100S0 dollars held
 If the  is not 1.0, the portfolio manager buys  put
options for each 100S0 dollars held
 In both cases, K is chosen to give the appropriate
insurance level
 Market value/(100S0)
Example 1
 Portfolio has a beta of 1.0

 It is currently worth $500,000
 The index currently stands at 1000
 What trade is necessary to provide
insurance against the portfolio value falling
below $450,000?
Solution
 500,000 with a beta of 1
 Thus 5 put options (5*100*1000)
 To determine the strike price, note that

 When stock portfolio has a value of
450,000, the stock index becomes:
1000*450,000/500,000=900
Fundamentals of Futures and Options Markets, 7th Ed, Ch 15, Copyright © John C. Hull 6
2010
Example 2
 Portfolio has a beta of 2.0

 It is currently worth $500,000 and index
stands at 1000
 The risk-free rate is 12% per annum
 The dividend yield on both the portfolio
and the index is 4%
 How many put option contracts should
be purchased for portfolio insurance?
Calculating Relation Between Index Level
and Portfolio Value in 3 months
 If index rises to 1040, it provides a 40/1000 or
4% return in 3 months
 Total return (incl. dividends)=5%
 Excess return over risk-free rate= total return
– risk free rate for 3 months=2%
 Rp-rf = beta *excess return = 2* 2%=4%
 Rp-rf =4% => Total return Rp=4% +rf =7%
 Increase in Portfolio Value=4+3–1=6%
 Portfolio value=500,000*(1+0.06)=$530,000
Calculating Relation Between Index Level
and Portfolio Value in 3 months
=(450,000-500,000)/500000
Determining the Strike Price (Table
15.2, page 329)
Value of Index in 3 Expected Portfolio Value

months in 3 months ($)
1,080 570,000
1,040 530,000
1,000 490,000
960 450,000
920 410,000
880 370,000
An option with a strike price of 960 will provide protection
against a 10% decline in the portfolio value
Currency Options
 Currency options trade on the NASDAQ
OMX
 There also exists an active over-the-counter
(OTC) market
 Currency options are used by corporations
to buy insurance when they have an FX
exposure
Examples
 A European call option to buy one million
euros with USD at an exchange rate of
1.40 dollars per euro.
 A European put option to sell ten millions

Australian dollars for USD at an exchange
rate of 0.90 dollars per Australian dollar.
2010
Range Forward Contracts
 Have the effect of ensuring that the exchange rate
paid or received will lie within a certain range
 When currency is to be paid it involves selling a put
with strike K1 and buying a call with strike K2
 When currency is to be received it involves buying
a put with strike K1 and selling a call with strike K2
 Normally the price of the put equals the price of the
call
 Consider a US company receiving one million
pound sterings in three months.
 The company could lock in by entering a short
forward contract with a strike price of, say, 1.52
dollars per pound.
 Suppose a company receives one million
 A short range forward contract
Payoff
Asset
Price
K1 K2
2010
Long put Short call FX Total

S<K1 (K1 -S) 0 S K1
K1≤S≤K2 0 0 S S
S>K2 0 -(S-K2 ) S K2
2010
 Consider a US company paying one million
 The company could lock in by entering a long
forward contract with a strike price of, say, 1.52
dollars per pound.
 Suppose a company pays one million
 A long range forward contract
Payoff
K1 K2 Asset
Price
2010
Short put Long call FX Total

S<K1 -(K1 -S) 0 -S -K1
K1≤S≤K2 0 0 -S -S
S>K2 0 (S-K2 ) -S -K2
2010
European Options on Stocks
with Known Dividend Yields
We get the same probability
distribution for the stock price at time
T in each of the following cases:
1. The stock starts at price S0 and
provides a dividend yield = q
2. The stock starts at price S0e–qT
and provides no income
European Options on Stocks
Paying Dividend Yield
continued
We can value European options by

reducing the stock price to S0e–qT and then
behaving as though there is no dividend
Extension of Chapter 10 Results
(Equations 15.1 to 15.3)
Lower Bound for calls:

 qT  rT
c  S0e  Ke
Lower Bound for puts
 rT  qT
p  Ke  S0e
Put Call Parity
c  Ke  rT  p  S 0 e  qT
Extension of Chapter 13 Results
(Equations 15.4 and 15.5)
c  S 0 e  qT N ( d1 )  Ke  rT N ( d 2 )
p  Ke  rT N ( d 2 )  S 0 e  qT N ( d1 )
ln( S 0 / K )  ( r  q   2 / 2)T
where d1 
 T
ln( S 0 / K )  (r  q   2 / 2)T
d2 
 T
Valuing European Index Options
We can use the formula for an option

on a stock paying a continuous
dividend yield
Set S0 = current index level
Set q = average dividend yield expected
during the life of the option
Using Forward/Futures Index
Prices (equations 15.6 and 15.7, page 336)
F0  S 0 e ( r  q )T  S 0 e  qT  F0 e  rT :
c  e  rT [F0 N(d1 )  KN ( d 2 )]
 rT
pe [ KN (  d 2 )  F0 N (  d1 )]
ln( F0 / K )   2T / 2
d1 
 T
d 2  d1   T
Currency Options: The Foreign
Interest Rate
 We denote the foreign interest rate by rf
 The return measured in the domestic
currency from investing in the foreign
currency is rf times the value of the
investment
 This shows that the foreign currency
provides a yield at rate rf
Valuing European Currency Options
 We can use the formula for an option

on a stock paying a continuous
dividend yield :
Set S0 = current exchange rate
Set q = rƒ
Formulas for European Currency
Options
(Equations 15.8 and 15.9 page 337)
 rf T
c  S0e N (d1 )  Ke  rT N ( d 2 )
rf T
p  Ke  rT N (  d 2 )  S 0 e N (  d1 )
ln( S 0 / K )  ( r  r   2 / 2)T
f
where d1 
 T
ln( S 0 / K )  ( r  r   2 / 2)T
f
d2 
 T
Using Forward/Futures Exchange
Rates
(Equations 15.10 and 15.11, page 338)
( r  r f )T rf T  rT
F0  S 0 e  S0e  F0 e
c  e  rT [ F0 N (d1 )  KN ( d 2 )]
p  e  rT [ KN ( d 2 )  F0 N (  d1 )]
ln( F0 / K )   2T / 2
d1 
 T
d 2  d1   T
The Binomial Model
S0u
p ƒu
S0
ƒ S0d
(1–
p)
ƒd
f = e-rt[pfu+(1– p)fd ]
The Binomial Model
continued
rT
e  d When no dividend yield of q
P
ud
ad
p When there is a dividend yield of q
ud
( r  q )T
ae for indices
( r  r f )T
ae for currencies

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Options on Stock Indices

 Contracts are on 100 times index; they are settled in

 Consider a call option on an index

 Portfolio has a beta of 1.0

 To determine the strike price, note that

 Portfolio has a beta of 2.0

Value of Index in 3 Expected Portfolio Value

 A European put option to sell ten millions

Long put Short call FX Total

Short put Long call FX Total

We can value European options by

Lower Bound for calls:

We can use the formula for an option

 We can use the formula for an option

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