CHAPTER 13 Options on Futures

In this chapter, we discuss option on futures contracts. This chapter is organized into:
1. Characteristics of Options on Physicals and Options on Futures. 2. The Market for Options on Futures 3. Pricing of Options on Futures 4. Price Relationship Between Options on Physicals and Options on Futures 5. Put-Call Parity for Options on Futures 6. Options on Futures and Synthetic Futures 7. Risk Management with Options on Futures

Chapter 13

Characteristics of Options on Physicals and Options Futures

Recall from Chapter 12 that options are written for a prespecified 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. The seller of a call option has the obligation to sell. Put Options. The buyer of a put option has the right but not the obligation to sell. The seller of a put option has the obligation to purchase.

Chapter 13

Characteristics of Options on Physicals and Options Futures

Prices of options on futures are closely related to prices of options on the underlying good.
Call Option on Futures Upon exercising a option on futures, the call owner:
Receives a long position in the underlying futures at the settlement price prevailing at the time of exercise. Receives a payment that equals the settlement price minus the exercise price of the option on futures.

The call owner would not exercise if the futures settlement price did not exceed the exercise price. Upon exercise, the call seller:
Receives a short position in the underlying futures at the settlement price prevailing at the time of exercise. Pays the long trader the futures settlement price minus the exercise price.

Chapter 13

Characteristics of Options on Physicals and Options Futures

On February 1, a trader buys a call option on a MAR euro futures contract with an exercise price of $0.44 per euro. On February 15, the call owner decides to exercise the call option. The futures settlement price is $.48. After gathering all the information, the owner has:
Future settlement price The exercise price The euro futures maturing Euro contract amount = $.48 = $.44/euro = March = 125,000 euros

Upon exercise, the call owner:

Receives a long position in the MAR euro futures contract. Receives a payment = F0 E $.48 - .44 (125,000) = $5000

Upon exercise, the call seller:

Receives a short position in the euro futures. Pay $5,000.

The traders can offset or hold their futures positions.

Chapter 13

Characteristics of Options on Physicals and Options Futures

Put Option on Futures
Upon exercising a option on futures, the put owner:
Receives a short position in the underlying futures contract at the settlement price prevailing at the time of exercise. Receives a payment that equals the exercise price minus the futures settlement price.

The put owner would not exercise unless the exercise price exceeded the futures settlement price. Upon exercise, the put seller:
Receives a long position in the underlying futures contract. Pays the exercise price minus the settlement price.

Chapter 13

Characteristics of Options on Physicals and Options Futures

On April 1, a trader buys a put option on a MAY wheat futures contract. The exercise price is $2.40/bushel and wheat contract is for 5,000 bushels. On April 4, the owner of the call option decides to exercise. The futures settlement price is $2.32/bushel.
Exercise price Wheat contract Futures settlement price The wheat futures matures Upon exercise, the put owner:
Receives a short position MAY Wheat futures contract. Receives a payment = F0 E $2.40-$2.32 (5,000) = $400

= $2.40/bushel = 5,000 bushels = $2.32/bushel. = May

Upon exercise, the put seller:

Receives a long position MAY Wheat futures contract. Pays $400.

The traders can offset or hold their futures positions.

Chapter 13

Characteristics of Options on Physicals and Options Futures

The following table summarizes the option examples discussed previously.

Results of Futures Option Exercises

Option Call Put Futures Results Owner holds long futures position. Seller holds short futures position. Owner holds short futures position. Seller holds long futures position. Cash Flows Owner receives F0 - E. Seller pays F0 - E. Owner receives E - F0. Seller pays E - F0.

where: F0 = futures settlement price at time of exercise E = exercise price of the futures option

The overall profitability of the transactions depends upon the original premium and the prices that become available before expiration of the option.

Chapter 13

The Market of Options on Futures

Figure 13.1 presents some illustrative quotations for options on futures.

Insert figure 13.1 here

Chapter 13

The Market of Options on Futures

Table 13.1 shows the trading volume for options on futures by type of commodity in the fiscal year ending September 30, 1995.

Table 13.1 Trading Volume for Futures Options

(Year Ending September 30, 2003)
Commodity Group Grain Oilseeds Livestock Other Agricultural Energy/Wood Metals Financial Instruments Currencies Total Source: Commodity Futures Trading Commission, Annual Report, 2003. Number of Contracts Traded (millions) 6.8 5.3 0.9 5.3 20.7 4.3 173.9 2.1 219.2

Chapter 13

The Market of Options on Futures

Product Profile: The NYMEX=s Crude Oil Futures Options
Contract Size: One NYMEX light, sweet, crude oil futures contract Strike Prices: Twenty strike prices in increments of 50 cents per barrel above and below the at-the-money strike price. The next 10 strike prices are in increments of $2.50 above the highest and below the lowest strike prices for a total of 61 strike prices (including the at-themoney strike price). Tick Size: One cent per barrel ($10 per contract) Price Quote: U.S. dollars and cents per barrel. Contract Months: Thirty consecutive months plus long-dated futures initially listed 36, 48, 60, 72, and 84 months prior to delivery. Expiration and final Settlement: Last trading day is three business days prior to the last trading day for the underlying futures contract. Trading Hours: Open outcry trading is conducted from 10:00 AM until 2:30 PM. Daily Price Limit: None.

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The Market of Options on Futures

Product Profile: The CME= S&P 500 Futures Options s

Contract Size: One S&P 500 stock index futures contract Strike Prices: Generally12 strikes, including the at-the-money strike. Increments between strike price generally are 25 index points. Number of strike prices increases as expiration approaches and increments between strike prices is reduced to a minimum of 5 index points. Tick Size: .1 index points or $25.00. Price Quote: Price is quoted in terms of Standard & Poor= 500 Index. s Contract Months: Four months in the March, June, September, December cycle plus the first two serial months not in the cycle for a total of 6 contract months. Expiration and final Settlement: Options that expire in the March, June, September, December cycle expire at the same time as the underlying futures contract. The two nonMarch cycle options expire on the third Friday for the contract month. Trading Hours: Floor: 8:30 a.m. to 3:15 p.m.; Globex: Monday through Thursday 3:30 p.m. to 8:15 a.m. with a shutdown period from 4:30 p.m. to 5:00 p.m. nightly. Sunday and holidays 5:30 p.m. to 8:15 a.m. Daily Price Limit: Trading halted when futures trading is halted

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The Market of Options on Futures

Product Profile: The CME= Eurodollar Futures Options s

Contract Size: One Eurodollar futures contract Strike Prices: Generally12 strikes, including the at-the-money strike. Increments between strike price generally are 25 index points. Number of strike prices increases as expiration approaches and increments between strike prices is reduced to a minimum of 5 index points. Tick Size: .01 index points or $25.00. Price Quote: Price is quoted in terms of the IMM 3-month Eurodollar index, 100 minus the yield on an annual basis for a 360-day year. Contract Months: Eight months in the March, June, September, December cycle plus the first two serial months not in the cycle for a total of 10 contract months. Expiration and final Settlement: Options on the March, June, September, December cycle cease trading at 5:00 a.m. Chicago Time (11:00 a.m. London Time) on the second London bank business day immediately preceding the third Wednesday of the contract month. The two non-March cycle options expire on the Friday immediately preceding the third Wednesday for the contract month. Trading Hours:Floor: 7:20 a.m.-2:00 p.m; Globex: Mon/Thurs 2:10 p.m.-7:05 p.m.; Shutdown period from 4:00 p.m. to 5:00 p.m. nightly; Sunday & holidays 5:30 p.m.-7:05 p.m. Daily Price Limit: No limit

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Pricing Options on Futures

Recall from Chapter 12:
European Options European options can be exercised only on the maturity date. American Options

American options can be exercised any time prior to maturity.

The Black-Scholes model focus best on European options which avoids problems with early exercise and dividends. When there is a dividend and the dividend rate varies, the Black-Scholes model is not suitable for valuing options on futures. The Black-Scholes model can be modified for forward option pricing.

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Graphical Approach to American Options on Futures

Figure 13.2 illustrates how European options prices are good approximations for American futures option prices

Insert figure 13.2 here

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Black-Scholes Model for Options on Forward Contracts

The Black-Scholes equation for option on forward contracts is:

C=e

- rt

[ F 0,t N( d * ) - E N( d * )] 1 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 = standard deviation of the forward contracts price

* 1

ln( F / E ) .5 2 t 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]

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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.

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Approximating European and American Futures Option Values

Table 13.2 compares the theoretical values for European and American options on futures. The table assumes that the option on futures expires in half a year and has an exercise price of $100. The risk-free rate of interest is 8% and the standard deviation of the percentage change in the futures price is 0.2.
Table 13.2 Comparison of European and Approximate American Futures Option Call Values
r = .08 = .20 t = .5 years E = 100 Approximate American 0.30 1.72 5.48 11.90 20.34

Futures Price 80 90 100 110 120

European 0.30 1.70 5.42 11.73 19.91

Source: G. BaroneBAdesi and R. Whaley, A Efficient Analytic Approximation of American Option Values,@ Journal of Finance, 42:2, June 1987, pp. 301B320.

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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 Whaleys 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 t<6 F/E < 0.98 B0.0630 0.98 <1.02 B0.1228 F/E F/E 1.02 0.0577 All F/E B0.0757 6 < 12 t B0.1372 B0.0775 0.1175 B0.0599 t 12 B0.0872 0.0073 0.0702 B0.0120 All t B0.1028 B0.0924 0.0806 B0.0606 Puts t<6 B0.1064 B0.0816 0.1286 B0.0191 6 < 12 t B0.0914 B0.0196 0.1906 0.0808 t 12 B0.1056 0.1336 30.3060 0.2287 All t B0.1014 B0.0406 0.1929 0.0537

Source: R. Whaley, A Valuation of American Futures Options: Theory and Empirical Tests,@ Journal of Finance, March 1986, p. 138.

The differences between the theoretical and market price are significant here.
Chapter 13 18

Efficiency of The Option on Futures Market

Some of the studies summarized in Table 13.4 compare actual prices with Black model prices.

Table 13.4 Tests of Efficiency for Futures Options

Study Whaley (1986) Jordan, McCabe, and Kenyon (1987) Ogden and Tucker (1987) Bailey (1987) Blomeyer and Boyd (1988) Wilson and Fung (1988) Key Results For S&P 500 futures options, market and theoretical prices are systematically different. For soybeans, compared the difference between actual market prices and the Black model price, with average differences being 4/100 of a cent per bushel. For currencies, futures options appear to be efficiently priced. For gold, futures options appear to be efficiently priced. In early trading of TBbond futures options, inefficiencies may have existed. However, inefficient prices were rare and difficult to exploit. For grain futures options, prices closely conformed to the Black model. In periods of high volatility, actual prices did not rise as much as Black model prices.

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Price Relationship Between Options on Physicals and Options on Futures

In this section, the pricing relationship between options on physicals and options on futures is considered, specifically for call options. The analysis is organized as follows:
1. European options 2. American options on underlying assets with no cash flow 3. American options on underlying assets with cash flow

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Price Relationship Between Options on Physicals and Options on Futures

The following assumption will be held for this analysis:
1. 2. The options have the same expiration and exercise price. The options are on the same underlying commodity.
One option is on the commodity itself.

One option is on the futures on the commodity.

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21

European Options on Physicals and Futures

Recall from Chapter 12 that at expiration a call option on the physical will be worth:
S-E For European options on futures, exercise can occur only at expiration, so it must be that: Ft,t - E = St - E For European options the exercise value for options on physicals and options on futures is the same.

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22

American Options on Physicals and Futures with No Underlying Cash Flows

For American options, any difference in value between options on physicals and options on futures results from the early exercise privilege. Table 13.5 shows the exercise values that the option on the futures can have given the option on physicals in percentage terms. The risk-free rate is assumed to be 15% and the percentage change in the underlying assets is .25.
Table 13.5 Percentage Difference in Value for Call Options on Futures and Options on Physicals
Assumptions: Underlying asset has no cash flows. r = .15 = .25 Ratio of Physical Price to Exercise Price 0.8 0.9 1.0 1.1 1.2 Days Until Expiration 30 0.00 0.00 0.29 0.61 1.22 60 0.00 0.00 0.56 1.15 2.13 90 0.00 0.47 1.02 1.72 2.89 180 1.20 1.58 2.48 3.79 5.52 270 2.02 3.15 4.51 6.34 8.70

Source: M. Brenner, G. Courtadon, and M. Subrahmanyam, A Options on the Spot and Options on Futures,@ Journal of Finance, 40:5, 1985, pp. 1303-1317.

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American Options on Physicals and Futures with Underlying Cash Flows

This analysis is particularly relevant to options on stock indexes and options on stock index futures.
Cash flows from the underlying good reduce its value.
When stock pays a dividend, the stock price drops by approximately the amount of the dividend.

These cash flows affect both the option on the physical and the option on the futures. The analysis focuses on underlying physical asset paying a continuous dividend (cash flow) equal to the risk-free rate of interest. Under conditions of certainty, a futures call option is worth the present value of: F0,t E, t = 0 Based on the perfect markets Cost-of-Carry Model the futures price will be: F0,t = S0(1 + C)
Chapter 13 24

American Options on Physicals and Futures with Underlying Cash Flows

For financial futures, the cost of carry is the risk-free interest rate. Assume a continuous dividend equal to the risk-free rate of interest. In this case, the cost of carry is zero, so the futures call option price equals:
F0,t = S0erte-rt = S0 Substituting the value of F0,t into the Black-Scholes OPM gives an adjusted Black-Scholes OPM of:
C f = e rt [ S 0 N( d* ) EN( d* )] 1 2

where: Cf = the price of a call option on the futures After adjusting the Black-Scholes model for continuous paying dividend:

C f = e-rt S 0 N( d * ) - e - rt EN( d * ) 1 2
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

The implications of this analysis for various dividend rates are:
Relative Prices of Options on Physicals and Futures Option Characteristics European Options American OptionNo Dividend American OptionContinuous Dividend Dividend Rate < Interest Rate Dividend Rate = Interest Rate Dividend Rate > Interest Rate where: Cf, Cp Pf, Pp Call Cf = Cp Cf > Cp Cf > Cp Cf = Cp Cf < Cp Put Pf = Pp Pf < Pp Pf < Pp Pf = Pp Pf > Pp

= call on the futures and call on the physical = put on the futures and put on the physical

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Put-Call Parity for Options on Futures

Recall that Put-Call Parity specifies a relationship between the price of call and put options.
For non-dividend paying assets put-call parity equals:

C - P = S0 - Ee-rt
where: C P E S0 r t = = = = = = value of a call with exercise price E value of a put with exercise price E exercise price of both the call and put stock price risk-free rate of interest time until the options expire

Chapter 13

27

Put-Call Parity for Options on Futures

Before expiration, for options on futures, the relationship can be expressed as:

Cf - Pf = (F0,t - E)e-rt
where: Cf Pf F0,t E r = futures call option with exercise price E = futures put option with exercise price E = current futures price = common exercise price for Cf and Pf = risk-free rate

= time until expiration for the futures and options

Comparing both equations shows the similar structure of put-call parity for options on physicals and on futures.

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Put-Call Parity for Options on Futures

Using continuous compounding, the Cost-of-Carry Model for a perfect market is:

F0,t = S0ert
Substituting this expression for the futures price into the above equation gives:

Cf - Pf = (S0ert - E)e-rt = S0 - Ee-rt

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Options on Futures and Synthetic Futures

Synthetic Futures A position that duplicates the profits and losses from a futures, but consists of positions in other instruments. Creating synthetic futures equals: Futures Call - Futures Put = Synthetic Futures Table 13.6 summarizes the rules for constructing synthetic positions.

Table 13.6 Rules for Creating Synthetic Instruments

Synthetic Futures Synthetic Call Synthetic Put Synthetic Short Futures Synthetic Short Call Synthetic Short Put = Call = Put = Call = Put = B Put = B Call B Put + Futures B Futures B Call B Futures + Futures

Note: A synthetic instrument has the same profit and loss characteristics as the actual instrument. However, the synthetic instrument does not necessarily have the same value as the actual instrument.

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Risk Management with Options on Futures

This section explores examples related to risk management including:
Portfolio Insurance Synthetic Portfolio Insurance and Put-Call Parity Risk and Return in Insured Portfolios

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Risk Management with Options on Futures Example

Assume: a stock index is currently at $100. Stocks in the index pay no dividends, and the expected return on the index is 10% with a standard deviation of 20%. A put option on the index with an exercise price of $100 is available and costs $4. Consider three investment strategies:
Portfolio A : (uninsured) Portfolio B: (half insured) Portfolio C: (fully insured) Buy the index; total investment $100. Buy the index and one-half of a put; total investment $102. Buy the index and one put; total investment $104.

At expiration, the three portfolios will have profits and losses computed using the following equations: Portfolio A: Portfolio B: Portfolio C: Index Value - $100 Index Value + .5 MAX{0, Index Value $100} - $102 Index Value + MAX{0, Index Value $100} - $104
Chapter 13 32

Risk Management with Options on Futures

Figure 13.4 graphs the profits and losses of these 3 portfolios.

Insert Figure 13.4 here

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33

Portfolio Insurance
Recall that in portfolio insurance, a trader transacts to insure that the value of a portfolio does not fall below a given amount.
Based on figure 13.4, portfolio C is an insured portfolio:
The value of portfolio C cannot fall below $100. To create portfolio C, a trader bought the index at $100 and bought an index put with an exercise price of $100.

The worst possible loss on portfolio C is $4. Portfolio C must always be worth at least $100 because the value can not fall below $100, so it an insured portfolio.

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Synthetic Portfolio Insurance and PutCall Parity

Recall that a synthetic call could be created from a long position in the underlying good plus a long put. Thus a synthetic call is:
Synthetic Call = Put + Index From Figure 13.4, the Put + Index portfolio has the same profits and losses as a call option with an exercise price of $100. Applying the put-call parity equation to the index example: Call = Put + Index - Ee-rt where: E = exercise price on the index option An instrument with the same value and profits and losses as a call can be created by holding a long put, long index, and borrowing the present value of the exercise price.

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35

Synthetic Portfolio Insurance and PutCall Parity

Synthetic Calls and Put-Call Parity Synthetic Call = Put + Index Put-Call Parity: Call = Put + Index - E-rt A synthetic call replicates the profits and losses from the call, but it does not have the same value as the call. The long put/long index/short bond portfolio duplicates the value and profits and losses of the call option.

From the put-call parity, there is another way to create a portfolio that exactly mimics the insured portfolios value at expiration. Call + E-rt = Put + Index We can hold a long call plus investing the present value of the exercise price in the risk-free asset.

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Risks Return on Insured Portfolios

Each of the portfolios A-C has different risk characteristics. To explore the risk properties of the portfolios assume that the return on the index follows a normal distribution with a mean of 10% and a standard deviation of 20%.
Terminal Values for Portfolios A-C. The portfolio values at expiration depend on the price of the index at expiration. For each, the terminal value is: Portfolio A = Index Portfolio B = Index + MAX{0, .5(100.00 - Index)} Portfolio C = Index + MAX{0, 100.00 - Index} What is the probability that each of the portfolios will have a terminal value equal to or less than $100?

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37

Risk Return in Insured Portfolios

Table 13.7 shows some portfolio values and the probabilities that each portfolio will be equal to or less than the given terminal value at the expiration date.

Table 13.7 Probability That the Terminal Portfolio Value Will Be Equal to or Less than a Specified Value
Terminal Portfolio Value 50.00 60.00 70.00 80.00 90.00 100.00 110.00 120.00 130.00 140.00 150.00 160.00 170.00 Uninsured Portfolio A 0.0014 0.0062 0.0228 0.0668 0.1587 0.3085 0.5000 0.6915 0.8413 0.9332 0.9773 0.9938 0.9987 Probabilities HalfBInsured Portfolio B 0.0000 0.0000 0.0002 0.0062 0.0668 0.3085 0.5000 0.6915 0.8413 0.9332 0.9773 0.9938 0.9987 Fully Insured Portfolio C 0.0000 0.0000 0.0000 0.0000 0.0000 0.3085 0.5000 0.6915 0.8413 0.9332 0.9773 0.9938 0.9987

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Risk Return in Insured Portfolios

Figure 13.5 graphs the terminal portfolio values from $50 to $170 and shows the probability for each portfolio that the terminal portfolio value will be below or equal to the given amount.

Insert Figure 13.5 here

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39

Risk Return in Insured Portfolios

Returns on Portfolios A-C
Table 13.8 shows the probability that each portfolio will achieve a return greater than a specified return.

Table 13.8 Probability of Achieving a Return Equal to or Greater than a Specified Return
Probabilities Portfolio Return -0.5000 -0.4000 -0.3000 -0.2000 -0.1000 0.0000 0.1000 0.2000 0.3000 0.4000 0.5000 Uninsured Portfolio A 0.9987 0.9938 0.9773 0.9332 0.8413 0.6915 0.5000 0.3085 0.1587 0.0668 0.0228 HalfBInsured Portfolio B 1.0000 1.0000 0.9996 0.9904 0.9066 0.6554 0.4562 0.2676 0.1292 0.0505 0.0158 Fully Insured Portfolio C 1.0000 1.0000 1.0000 1.0000 1.0000 0.6179 0.4129 0.2297 0.1038 0.0375 0.0107

This is a tradeoff between return and risk on the portfolios. The portfolios having a higher return also have a higher risk.
Chapter 13 40

Risk Return in Insured Portfolios

Figure 13.6 graphs the probabilities for each portfolio for a range of returns from -50% to 50%.

Insert Figure 13.6 here

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Why Options on Futures

Some reasons for the popularity of options on futures are:
1. A futures position exposes a trader to a theoretically unlimited risk of gain or loss, but this is not true for the buyer of a futures option. 2. Options on futures dominate options on physicals in some markets because the futures market for some goods is much more liquid than the market for the physical good itself. 3. Options on futures generally require less investment than options on the physical good itself.

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