Slides 10

Futures Options
Chapter 16
Fundamentals of Futures and Options Markets, 8th Ed, Ch 16, Copyright © John C. Hull 2013 1
Introduction
 Up until this point we considered options which when exercised will give the
right to buy or sell an underlying asset
 These are termed spot options or options on spot
 Futures options when exercised will give the holder a position in a futures
contract
 Futures call allows for the right to enter into a long futures contract at a given
strike
 Futures put allows for the right to enter into a short futures contract at a given
strike
Options on Futures (Calls)
 Futures options are generally American and usually expires on or a few days
before the earliest delivery date of the underlying futures contract.
 Call futures option allows holder to acquire:
 Long position in futures (at the most recent settlement price)
 Cash amount equal to excess of futures price at the most recent settlement over strike
price
 An investor buys a call futures option contract on gold. The contract size is
100 ozs. The strike price is 900.
 If the investor exercises when the July gold futures price is 940 and the most recent
settlement price is 938, the investor receives a cash amount equal to (938-900) x 100 =
$3,800 and receives a long futures contract for delivery at 938
Mechanics of Call Futures Options
When a call futures option is exercised the holder acquires

1. A long position in the futures
2. A cash amount equal to the excess of the futures price at the most recent
settlement over the strike price
An investor buys a call futures option contract on gold. The contract size is 100 ozs. The strike
price is 900.
 If the investor exercises when the July gold futures price is 940 and the most recent
settlement price is 938, the investor receives a cash amount equal to (938-900) x 100 =
$3,800 and receives a long futures contract for delivery at 938
Mechanics of Put Futures Option
 Put futures option enables holder to acquire:

 Short position in futures (at the most recent settlement price)
 Cash amount equal to excess of strike price over futures price at most recent settlement
 An investor buys a September put futures option contract on corn. The

contract size is 5,000 bushels. The strike price is 300 cents.
 If the investor exercises when the September corn futures price is 280 and the most
recent settlement price is 279, the investor receives a cash amount of (3.00-2.79) x 5,000
= $1,050 and a short futures contract for delivery at 279.
Example 16.1 (page 351)
 July call option contract on gold futures has a strike of $1800 per ounce. It is
exercised when futures price is $1,840 and most recent settlement is $1,838.
One contract is on 100 ounces
 Trader receives
 Long July futures contract on gold
 $3,800 in cash
Call Futures Options
 Explanation of Example 16.1:
 BUY July call futures option contracts on gold.
 Exercise price = 1800 per announce
 Asset underlying one option is 100 ounces of gold
 July Futures price at the time of option exercised is $1840
 Most recent settlement price for July futures contract is $1838.
What is the Total Payoff from the Call futures position?

 Long Futures position
 Cash amount receives: (1838 – 1800)*100 = $3800
Close out future immediately to obtain: (1840-1838)*100 = 200 [Gain]

TOTAL PAYOFF : 3800+200 = $4000.
Example 16.2 (page 351)
 Sept put option contract on corn futures has a strike price of 300 cents per
bushel.
 It is exercised when the futures price is 280 cents per bushel and the most
recent settlement price is 279 cents per bushel. One contract is on 5000
bushels
 Trader receives
 Short Sept futures contract on corn
 $1,050 in cash
Put Futures Options
 Explanation of Example 16.2:
 BUY September put futures option contracts on corn.
 Exercise price = 300 cents
 Asset underlying one option is 5000 bushels
 July Futures price at the time of option exercised is $280
 Most recent settlement price for July futures contract is $279.
What is the Total Payoff from the Put futures position?

 Short Futures position
 Cash amount receives: (3.00 – 2.79)*5000 = $1,050
Close out future immediately to obtain: (2.79-2.80)*5000= -50 [Loss]

TOTAL PAYOFF : 1,050 - 50 = $1000.
The Payoffs
If the futures position is closed out immediately:

Payoff from call = F – K
Payoff from put = K – F
where F is futures price at time of exercise
Potential Advantages of Futures Options over Spot
Options
 Futures contract may be easier to trade than underlying asset
 Futures contracts may in some instances be more liquid (i.e. easier to trade) than
spot assets e.g: commodities
 Futures prices can be found immediately by looking on the exchange
 Contrast this with Future spot prices which are uncertain (as they occur in the
future)
 Exercise of the option does not lead to delivery of the underlying asset
 Futures options and futures usually trade on the same exchange
 Futures options may entail lower transactions costs
European Futures Options vs European Spot
Options (for same strike)
Payoff European Call Option (Spot) Payoff European Futures call
 Where ST is the spot price at the  Where FT is the futures price at the
option’s maturity option’s maturity
max( ST  K , 0) max( FT  K , 0)
European futures options and spot options are equivalent when futures
contract matures at the same time as the option as
ST  FT
It is common to regard European spot options as European futures options
when they are valued in the over-the-counter markets
Put-Call Parity
Strategy I Strategy II
Strategy I: buy a European call Strategy II: buy a European put futures
on a futures contract and invest Ke-rT option, enter a long futures contract,
of cash and invest F0e-rT
At time T:
At time T:
FT ≤ K FT > K FT ≤ K FT > K
Buy Call 0 FT – K Long Futures FT - F0 FT - F0
Invest Ke–rT K K Buy Put K-FT 0
Total K FT
Invest F0erT F0 F0
Total K FT
Put-Call Parity
 If two portfolios provide the same return, they must cost the same
to set up, otherwise an opportunity for arbitrage exists
c + Ke-rT = p + F0e-rT
since futures cost nothing to set up initially
14
Other Relations
F0 e-rT – K < C – P < F0 – Ke-rT
[Recall - Tutorial Q15.12]

S0 e-rT – K < C – P < S0 – Ke-rT
Bounds for European futures options:

c ≥ max[(F0 – K)e-rT, 0]
p ≥ max [(K – F0)e-rT, 0]
Binomial Tree Example
 Suppose that:
 1-month call option on futures has a strike price of $29
 In one month the futures price will be either $33 or $28
 Assume risk-free rate = 6% p.a. continuous compounding
Futures Price = $33
Option Price = $4
Futures price = $30
Option Price=?
Futures Price = $28
Option Price = $0
What is the price of the portfolio at time zero and at time T?
Setting Up a Riskless Portfolio
 Consider a portfolio:
Long D futures, short 1 call futures option
3D – 4
-2D
 Portfolio is riskless when 3D – 4 = – 2D
solve for: D = 0.8
Binomial Pricing
 The riskless portfolio is:

long 0.8 futures
short 1 call option
 The value of the portfolio in 1 month is
- If stock price go up: 3(0.8) – 4 = -1.6

- If stock price go down: -2 (0.8)= -1.6
 The value of the portfolio today is
-1.6e – 0.06/12 = –1.592
 Since value of futures is zero, then 0 – value of call futures option = -1.592.
Value of call futures option = $1.592
Generalization of Binomial Tree Example (Figure
16.2, page 356)
 A derivative lasts for time T and is dependent on a futures price
F0u
ƒu
F0
ƒ
F0d
ƒd
Generalization
(continued)
 Consider the portfolio that is long D futures and short 1 derivative

F0u D - F0 D – ƒu
F0d D- F0D – ƒd
 Note the futures costs nothing to set up initially
 The portfolio is riskless when:
F0u D - F0 D – ƒu = F0d D - F0 D – ƒd
ƒu  f d

F0 u  F0 d
Generalization
(continued)
 Value of portfolio at time T: Substituting for D we obtain

F0u D – F0D – ƒu
 Value of portfolio today: ƒ = [ p ƒu + (1 – p )ƒd ]e–rT
(F0u D – F0D – ƒu)e–rT
 Cost of portfolio today: where 1 d
–f since the futures costs nothing p
to set up initially ud
 Hence ƒ = – [F0u D – F0 D – ƒu]e–rT
Growth Rates For Futures Prices
 A futures contract requires no initial investment

 In a risk-neutral world the expected return should be zero
 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)
Valuing European Futures Options
 We can use the formula for an option on a stock paying a

dividend yield
 S0 = current futures price, F0
 q = domestic risk-free rate, r
 Setting q = r ensures that the expected growth of F in a risk-

neutral world is zero
 The result is referred to as Black’s model because it was first
suggested in a paper by Fischer Black in 1976
Black’s Model
(Equations 16.7 and 16.8, page 358)
 The formulas for European options on futures are known as

Black’s model
c  e  rT F0 N ( d1 )  K N ( d 2 )
p  e  rT K N ( d 2 )  F0 N ( d1 )
ln( F0 / K )   2T / 2
where d1 
 T
ln( F0 / K )   2T / 2
d2   d1   T
 T
How Black’s Model is Used in Practice
 European futures options and spot options are equivalent when future
contract matures at the same time as the otion.
 This enables Black’s model to be used to value a European option on the
spot price of an asset
 One advantage of this approach is that income on the asset does not have to
be estimated explicitly
Using Black’s Model Instead of Black-Scholes
(Example 16.5, page 359)
 Consider a 6-month European call option on spot gold

 6-month futures price is 1860, 6-month risk-free rate is 5%, strike price is
1800, and volatility of futures price is 20%
 Value of option is given by Black’s model with F =1860, K=1800, r=0.05,
0
T=0.5, and s=0.2
 It is 132.56
Effect of Futures Option Prices vs Spot Option
Prices
American Options
 If futures prices are higher than spot prices (normal market), an American call
(put) on futures is worth more (less) than a similar American call (put) on
spot.
 When futures prices are lower than spot prices (inverted market) the reverse
is true
Put-Call Parity Results: Summary
Nondividend Paying Stock: Foreign exchange:

 rT
c  Ke  p  S0  rT
c  Ke  p  S0e
 rf T
Indices: Futures:
 rT  qT
c  Ke  p  S0e  rT
c  Ke  p  F0 e  rT
Summary of Key Results from Chapters 15
and 16
 We can treat stock indices, currencies, & futures like a stock paying a
continuous dividend yield of q
 For stock indices, q = average dividend yield on the index over the option
life
 For currencies, q = rƒ
 For futures, q = r

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Futures Options

 These are termed spot options or options on spot

When a call futures option is exercised the holder acquires

 Put futures option enables holder to acquire:

 An investor buys a September put futures option contract on corn. The

What is the Total Payoff from the Call futures position?

Close out future immediately to obtain: (1840-1838)*100 = 200 [Gain]

What is the Total Payoff from the Put futures position?

Close out future immediately to obtain: (2.79-2.80)*5000= -50 [Loss]

If the futures position is closed out immediately:

since futures cost nothing to set up initially

F0 e-rT – K < C – P < F0 – Ke-rT

[Recall - Tutorial Q15.12]

Bounds for European futures options:

 The riskless portfolio is:

- If stock price go up: 3(0.8) – 4 = -1.6

 A derivative lasts for time T and is dependent on a futures price

 Consider the portfolio that is long D futures and short 1 derivative

 Value of portfolio at time T: Substituting for D we obtain

 A futures contract requires no initial investment

 We can use the formula for an option on a stock paying a

 Setting q = r ensures that the expected growth of F in a risk-

 The formulas for European options on futures are known as

 Consider a 6-month European call option on spot gold

Nondividend Paying Stock: Foreign exchange:

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