Futures Options Chapter 16 16.1 The Goals of Chapter 16 Introduce mechanics of futures options Properties of futures options Pricing futures options using binomial trees Pricing futures options with Blacks formula Introduce futures-style options 16.2 16.1 Mechanics of Futures

Options 16.3 Mechanics of Futures Options When a call futures option is exercised, the holder acquires 1. A long position in the futures with the delivery price to be (the most recent settlement price) 2. A cash amount equal to the excess of the futures price over the strike price When

a put futures option is exercised, the holder acquires 1. A short position in the futures with the delivery price to be (the most recent settlement price) 2. A cash amount equal to the excess of the strike price over the futures price 16.4 Mechanics of Futures Options If the futures position is closed out immediately, Payoff from call = Payoff from put =

where is the futures price at the time of exercise Suppose that the futures price on gold (100 ounces per contract) at the time of exercise is 940/ounce and the most recent settlement price is 938/ounce Holders of the call futures option with = 900 can receive (938 900) 100 = 3,800 and a long futures on gold If the holders close out the futures position immediately by entering into a short position with with = 940, the gain on the futures contract is (940 938) 100 = 200 16.5

Futures Options vs. Spot Options Advantages of futures options Futures contracts may be more convenient to trade than underlying assets 1000 barrels of oil vs. one oil futures contract Futures prices are more readily available Treasury bonds in dealers markets vs. Treasury bond

futures on exchanges The liquidity of futures contract is in general better than underlying assets This is because the leverage effect of the margin mechanism or that many speculators intend to bid the direction of the price movement but do not want to hold the underlying assets physically 16.6 Futures Options vs. Spot Options Exercise of the futures option does not lead to the

delivery of the underlying asset The futures contracts are usually closed out before maturity and thus settled in cash Futures options and futures usually trade in pits side by side on the same exchanges In most cases, if an exchange offers a futures contract, it also offers the corresponding futures option contract This arrangement can facilitates the needs of hedging, arbitrage, and speculation and in effect enhance the overall

trading volume Futures options may entail lower transactions costs than spot options in many situations 16.7 Futures Options vs. Spot Options European-style futures and spot options (with the same and ) If the futures contract matures at the same time as the futures option, then , where and are the

futures and spot prices on that maturity date Thus the futures and spot options are equivalent, i.e., their payoffs at and worth today are the same Note that most of the futures options traded on exchanges are American-style 16.8 Futures Options vs. Spot Options American-style futures and spot options (with the same and ) When (normal markets),

An American call (put) futures option is worth more (less) than the corresponding American spot call (put) option Two reasons (taking call options as example): Note that call futures options are more ITM and thus more likely to be exercised than call spot options due to When American call futures options are exercised, holders can acquire , which is higher than the exercise value of the corresponding American call spot options, When (inverted markets), the reverse is true The above relations are true when the maturity of futures is equal to or later than

16.9 16.2 Properties of Futures Options 16.10 Properties of Futures Options Put-call parity for futures options Consider the following two portfolios: Portfolio A: a European call futures option + of cash Portfolio B: a European put futures option + a long futures contract (with the delivery price ) + of cash

Portfolio A Call futures option Cash Total Total Portfolio B Put futures option Long futures Cash Cash Total Total 16.11 Properties of Futures Options

Due to the law of one price, Portfolios A and B must therefore be worth the same today (Note that the futures is worth zero initially) The above equation is known as the put-call parity for futures options Comparing to the put-call parity for spot options, i.e., , the only difference is to replace with With the same replacement, we can derive the lower and upper bounds for futures options by modifying the counterparts for spot options 16.12 Properties of Futures Options

Futures options Spot options Lower bound for European calls Lower bound for European puts Upper bound for European calls Upper bound for European puts Lower bound for American calls Lower bound for American puts Upper bound for American calls Upper bound for American puts Put-call parity for American options The red indicate that the replacement of with is not applicable 16.13

16.3 Pricing Futures Options with Binomial Tree Model 16.14 Binomial Tree for Futures Options One-period binomial tree model for futures options A 1-month call option on futures has a strike price of 29

The current futures price is 30 and it will move either upward to 33 or downward to 28 over 1 month = 30 =? = 33 =4 = 28 =0 16.15 Binomial Tree for Futures Options

Consider a portfolio P: long D futures short 1 call futures option 3D 4 Note that the payoff for one-share 2Dlong futures is Portfolio P is riskless when 3D 4 = 2D, which implies D = 0.8 The value of Portfolio P after 1 month is 3 x 0.8 4 = 2 x 0.8 = 1.6 16.16

Binomial Tree for Futures Options Since Portfolio P is riskless, it should earn the risk-free interest rate according to the no-arbitrage argument The value of Portfolio P today is 1.6 = 1.592, where 6% is the risk-free interest rate The negative amount represents a positive income from constructing Portfolio P The riskless Portfolio P consists of long 0.8 futures and short 1 call futures option

The value of the futures is zero So, the sales proceeds of the call futures option is 1.592, which reflects exactly its current worth 16.17 Binomial Tree for Futures Options Generalization of one-period binomial tree model Consider any derivative lasting for time and its payoff is dependent on a futures price

Assume that the possible futures price at T are and , where and are constant multiplying factors for the upper and lower branches and are payoffs of the derivative corresponding to the 16.18 Binomial Tree for Futures Options Construct Portfolio P that longs D shares and shorts 1 derivative. The payoffs of Portfolio P are ( 0 0 ) ( 0 0 ) Portfolio P is riskless if and thus

= 0 0 Note that in the prior numerical example,, , , and , so the solution of for generating a riskless portfolio is 0.8 16.19 Binomial Tree for Futures Options Value of Portfolio P at time is (or equivalently ) Value of Portfolio P today is thus The initial investment (or the cost) for Portfolio P is Hence Substituting for in the above equation, we obtain

, where 16.20 Binomial Tree for Futures Options Note that in the above example, and , so . As a result, the value of the futures option is If the American-style futures call is considered, it is necessary to compare with and the larger one is the final option value

16.21 Binomial Tree for Futures Options Comparing with the binomial tree model for an option on a stock paying a continuous dividend yield introduced in Ch. 15, there are two differences: 1. Ch. 15 considers rather than 2. In Ch. 15, the risk-neutral probability equals Use the formula for an option on a stock paying a continuous dividend yield to price futures price Set = current futures price, Set = domestic risk-free rate, , so

Note that implies that the expected growth of in the riskneutral world is zero and setting can achieve the same effect 16.22 Growth Rates For Futures Prices The reasons for the zero expected growth rate of futures price in the risk-neutral world All futures with different maturity require no initial investment, i.e., their value are zero as they are created Therefore in the risk-neutral world, the present

value of expected payoff for any maturity , which implies for any 16.23 Growth Rates For Futures Prices Consequently, the expected growth rate of the futures price is therefore zero The futures price can therefore be treated like a stock paying a dividend yield of r This is consistent with the results we have presented so far (put-call parity, bounds, binomial trees) Based on the same reasoning, we can modifying

the Black-Scholes formula to price futures options shown in the next section 16.24 Summary of Key Results from Chapters 15 and 16 We can treat stock indices, currencies, and futures like a stock paying a continuous dividend yield of For stock indices, = average dividend yield on the index over the option life For currencies, For futures,

16.25 16.4 Pricing Futures Options with Blacks Model 16.26 Blacks Model for Pricing Futures Options The Black-Scholes formula to price an option on a stock paying a continuous dividend yield ,

, where Black (1976) found that by replacing with and with , the Black-Scholes formula can be applied to pricing futures option 16.27 Blacks Model for Pricing Futures Options Blacks model for pricing futures options: ,

, , where 16.28 Blacks Model for Pricing Spot Options It is known on page 16.8 that European futures and spot options are equivalent when future contract matures at the same time as the option This enables Blacks model to be used to value a European option on the spot price of an asset

Traders like to use Blacks model rather than the BlackScholes model to valuing European spot options The variable is set to the futures or forward prices of the underlying asset maturing at the same time as the option If the futures or forward prices with exactly the same maturity are not available, they interpolate as necessary 16.29 Blacks Model for Pricing Spot Options Apply Blacks model to pricing spot option Consider a 6-month European call option on spot gold 6-month futures price is 620, 6-month risk-free rate

is 5%, strike price is 600, and volatility of futures price is 20% Value of this option is given by Blacks model with , , , , and It is 44.19 If the market is perfect and there is no arbitrage opportunity in it, the option value derived with Blacks model should be identical to the one 16.30 derived with Black-Scholes formula Blacks Model for Pricing Spot Options The advantage of Blacks model to price

spot option For currency options, considering can avoid the estimation of the foreign interest rate, , because equals theoretically For index options, considering can avoid the estimation of the aggregate dividend yield of the index portfolio, , because equals theoretically 16.31 16.5 Futures-Style Options 16.32 Futures-Style Options A

futures-style option is a futures contract on the option payoff Note that to trade either spot or futures options, traders should pay (receive) cash up front In contrast, traders who trade a futures-style option post margin in the same way that they do on a regular futures contract The contract is settled daily to reflect the current option value and the final settlement price is the payoff (or equivalently the final value) of the option Due to the attraction of the leverage effect, some exchanges trade futures-style options in preference 16.33 to regular futures options

Futures-Style Options Note that the futures price for a futures-style option is the price that would be paid for the option at maturity, i.e., Blacks formula can be interpreted as the expected present value of the option payoff at maturity, i.e., Blacks formulae on page 16.28 are equal to , The futures price for a call futures-style option is The futures price for a put futures-style option is 16.34