Notes on Use of the LLP Option Pricing Model for Puts

The LLP option pricing model is based on a least-squares regression equation

that uses the natural logarithms of (asset price/strike price) to predict the
natural logarithms of (option price/strike price). The price curve generated in
logarithms is a parabola whose values are converted into arithmetic terms
by computing the antilog values.
The accuracy of LLP option price curves in matching actual market prices is
illustrated by the chart on the following worksheet. For this sample of sixteen
put options, the predictive price curve almost completely obscures the original
market prices.
Currently, the LLP pricing spreadsheet is arranged to contain up to twenty
combinations of asset price, strike price and call option price. The minimum
number needed to compute a price curve is three combinations
Price data should be entered in columns A, B and C. On the worksheet,
data to be entered is shown in black numerals, calculation formula cells in
blue, and output formula cells in red. The formula cells have not been
protected against accidental changes by the user, thus it is recommended
that file copies be made of the LLP and Black/Scholes worksheets.
The least squares regression computations take place starting at Column J,
and ultimately produce the A, B and C coefficients of the parabolic equation.
Values generated by the model, in addition to the predicted option prices,
include the intrinsic values (for puts, equal to the strike price less the asset
price at each point), hedge ratio (the slope of the curve at each point), and
upper and lower breakeven prices for each delta-neutral hedge -- the points at
which the slope line (not shown) intersects the intrinsic value and the horizontal axis.
One important note in using the LLP model is to recall that the price curve
in natural logs is a parabola. This means that when the predicted curve is carried
outside a "relevant" range there are unusual price results -- such as the
price curve intersecting and passing through the intrinsic value line. The charts
on the LLP worksheets show how well the model describes actual market
prices when the calculations fall within the range bounded by the horizontal
axis (where the option price is equal to zero) and the intrinsic value line.
If the numeral 2 is entered in cell H3, then the ratio (between zero and 1.0)
entered in cell H2 becomes the input hedge ratio for every point on the
price curve in place of the delta values originally computed. A new ratio
may be inserted in cell H2 in order to reflect the bullish or bearish feelings
of the user regarding the underlying asset price. A larger ratio makes the
option's price change at a greater rate per one unit change in the underlying
price, and means that the underlying asset may be hedged with fewer
options. The new ratio entered in cell H2 affects options at each strike price,
although you may be interested in changing a specific one.
The upper and lower breakeven prices at expiration will change with the
new ratio entered. If cell H3 is left blank or contains anything other than the
numeral 2 the ratio in cell H2 will not affect the calculated option prices.

Source of data for futures and option prices: Chicago Mercantile Exchange.

new ratio =
number =

16

if H3 = 2

0.50
0

Sept 08 Euro FX Futures Put Options

April 14, 2008
P
S
Put
Predicted
Asset
Strike
Option
Option
Intrinsic
Hedge
Lower
Upper
Price
Price
Price
Price
Value
Ratio
B-E
B-E
---------------- ----------------- ---------------- ---------------- ---------------- ---------------- ---------------- ----------------1.5679
1.600
0.0585
0.0586
0.0321
-0.6178
1.4732
1.6626
1.5679
1.595
0.0554
0.0554
0.0271
-0.5912
1.4742
1.6616
1.5679
1.585
0.0496
0.0495
0.0171
-0.5401
1.4761
1.6597
1.5679
1.570
0.0417
0.0416
0.0021
-0.4685
1.4789
1.6569
1.5679
1.565
0.0392
0.0392
-0.0029
-0.4460
1.4800
1.6558
1.5679
1.560
0.0369
0.0369
-0.4243
1.4809
1.6549
1.5679
1.555
0.0346
0.0347
-0.4032
1.4821
1.6537
1.5679
1.550
0.0325
0.0326
-0.3829
1.4830
1.6528
1.5679
1.545
0.0305
0.0306
-0.3632
1.4839
1.6519
1.5679
1.540
0.0287
0.0287
-0.3442
1.4845
1.6513
1.5679
1.535
0.0269
0.0269
-0.3260
1.4854
1.6504
1.5679
1.530
0.0252
0.0252
-0.3084
1.4862
1.6496
1.5679
1.525
0.0236
0.0236
-0.2915
1.4869
1.6489
1.5679
1.520
0.0220
0.0220
-0.2753
1.4880
1.6478
1.5679
1.515
0.0206
0.0206
-0.2597
1.4886
1.6472
1.5679
1.510
0.0192
0.0192
-0.2448
1.4895
1.6463
0.0000
#NUM!
#NUM!
#NUM!
0.0000
#NUM!
#NUM!
#NUM!
0.0000
#NUM!
#NUM!
#NUM!
0.0000
#NUM!
#NUM!
#NUM!

Predicted Option Price Curve

---------------------------------------------A = -3.6548459
B = -17.744513
C = -29.777627

S/E
---------------0.9799375
0.9830094
0.98921136
0.99866242
1.00185304
1.0050641
1.00829582
1.01154839
1.01482201
1.01811688
1.02143322
1.02477124
1.02813115
1.03151316
1.03491749
1.03834437
0
0
0
0

Sept 08 Euro FX Futures Put Options

0.0600

2.59%

0.0500
Option Price

The jump in strike prices causes

a jagged progression of prices
instead of a smooth curve on the
chart.

Precicted
W/E
---------------0.03660912
0.03475228
0.0312458
0.02648574
0.02502703
0.02362998
0.02229313
0.02101501
0.0197941
0.01862886
0.01751773
0.01645916
0.01545155
0.01449332
0.01358287
0.01271863
0.02586548
0.02586548
0.02586548
0.02586548

0.0700

Time Premium where P = S

At the strike price, height of option

price curve as percent of the
strike price. Indicator of relative
volatility and value of remaining
time to expiration.

Predicted
LN W/E
----------------3.3074576
-3.35951
-3.4658702
-3.6311486
-3.6877987
-3.7452389
-3.8034764
-3.8625181
-3.9223713
-3.9830433
-4.0445414
-4.106873
-4.1700458
-4.2340673
-4.2989453
-4.3646874
-3.6548459
-3.6548459
-3.6548459
-3.6548459

0.0400
0.0300
0.0200
0.0100
0.0000
1.60 1.59 1.58 1.57 1.56 1.56 1.55 1.55 1.54 1.54 1.53 1.53 1.52 1.52 1.51 1.51
-0.01000
5 5
0
5
0
5
0
5
0
5 0
5
0
5
0
Put Option Market Prices
Intrinsic Value

Strike Price
LLP Predicted Prices

Note: On this chart the predicted prices overlay the put market prices due to high
correlation between the two series.
Some of the intrinsic values in Column E were deleted in order to improve the chart
shown above. If needed they can be recalculated by copying the formula in cell E16.

W/E
---------------0.0365625
0.03473354
0.03129338
0.02656051
0.02504792
0.02365385
0.0222508
0.02096774
0.0197411
0.01863636
0.01752443
0.01647059
0.01547541
0.01447368
0.01359736
0.01271523
0
0
0
0
----------------0.8087893

LN S/E
----------------0.0202665
-0.0171366
-0.0108473
-0.0013385
0.00185132
0.00505132
0.0082616
0.01148221
0.01471323
0.01795473
0.02120676
0.02446941
0.02774273
0.03102681
0.03432171
0.03762749
0
0
0
0
---------------0.18612052

LN W/E
----------------3.3087322
-3.3600494
-3.4643489
-3.6283298
-3.6869644
-3.7442295
-3.8053771
-3.8647701
-3.9250525
-3.9826406
-4.0441594
-4.106179
-4.168503
-4.2354232
-4.2978796
-4.3649547
0
0
0
0
----------------61.987593

SUM1
---------------0.06705637
0.0575798
0.0375787
0.00485643
-0.0068258
-0.0189133
-0.0314385
-0.0443761
-0.0577502
-0.0715072
-0.0857635
-0.1004758
-0.1156457
-0.1314117
-0.1475106
-0.1642423
0
0
0
0
---------------0.00696635

SUM2
----------------0.0202665
-0.0171366
-0.0108473
-0.0013385
0.00185132
0.00505132
0.0082616
0.01148221
0.01471323
0.01795473
0.02120676
0.02446941
0.02774273
0.03102681
0.03432171
0.03762749
0
0
0
0
---------------0.00016566

SUM3
----------------3.3087322
-3.3600494
-3.4643489
-3.6283298
-3.6869644
-3.7442295
-3.8053771
-3.8647701
-3.9250525
-3.9826406
-4.0441594
-4.106179
-4.168503
-4.2354232
-4.2978796
-4.3649547
0
0
0
0
----------------0.0285767

SUM4
SUM5
SUM6
SUM7
S8
S9
T1
---------------- ---------------- ----------------- --------------------------------------------------------- ----------------0.00041073 -8.324E-006 -0.001359 1.687E-007 0.00480129 8.463E-005
-0.0877166455
0.00029366 -5.032E-006 -0.0009867 8.624E-008
0.00011766 -1.276E-006 -0.0004076 1.384E-008
T2
T3
C2
1.792E-006 -2.398E-009 -6.500E-006 3.210E-012 --------------------------------- ----------------3.427E-006 6.345E-009 -1.264E-005 1.175E-011 2.881E-006 -0.0015875
0.0048012936
2.552E-005 1.289E-007 -9.554E-005 6.511E-010
6.825E-005 5.639E-007 -0.0002597 4.659E-009
DV
C1
C3
0.00013184 1.514E-006 -0.0005095 1.738E-008 ---------------- ----------------- ----------------0.00021648 3.185E-006 -0.0008497 4.686E-008 56.7339307 -0.0900641
0.0001634624
0.00032237 5.788E-006 -0.0012839 1.039E-007
0.00044973 9.537E-006 -0.0018188 2.023E-007
0.00059875 1.465E-005 -0.0024586 3.585E-007
0.00076966 2.135E-005 -0.0032083 5.924E-007
0.00096266 2.987E-005 -0.0040773 9.267E-007
0.00117798 4.043E-005 -0.0050628 1.388E-006
0.00141583 5.327E-005
-0.00618 2.005E-006
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
---------------5.914E-006

D1
CP
---------------- ----------------0.00234749 -29.777627
D2
BP
---------------- -----------------7.883E-005 -17.744513
AP
----------------3.6548459