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Introduction

Chapter 1

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.1

The Nature of Derivatives

A derivative is an instrument whose value depends on the values of other more basic underlying variables

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.2

Examples of Derivatives

Futures Contracts Forward Contracts Swaps Options

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.3

Ways Derivatives are Used


To hedge risks To speculate (take a view on the future direction of the market) To lock in an arbitrage profit To change the nature of a liability To change the nature of an investment without incurring the costs of selling one portfolio and buying another
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.4

Futures Contracts
A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time)

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.5

Exchanges Trading Futures


Chicago Board of Trade Chicago Mercantile Exchange Euronext Eurex BM&F (Sao Paulo, Brazil) and many more (see list at end of book)

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.6

Futures Price
The futures prices for a particular contract is the price at which you agree to buy or sell It is determined by supply and demand in the same way as a spot price

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.7

Electronic Trading
Traditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.8

Examples of Futures Contracts


Agreement to: buy 100 oz. of gold @ US$600/oz. in December (NYMEX) sell 62,500 @ 1.9800 US$/ in March (CME) sell 1,000 bbl. of oil @ US$65/bbl. in April (NYMEX)
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.9

Terminology

The party that has agreed to buy has a long position The party that has agreed to sell has a short position

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.10

Example
January: an investor enters into a long futures contract on COMEX to buy 100 oz of gold @ $600 in April April: the price of gold $615 per oz What is the investors profit?
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.11

Over-the Counter Markets


The over-the counter market is an important alternative to exchanges It is a telephone and computer-linked network of dealers who do not physically meet Trades are usually between financial institutions, corporate treasurers, and fund managers
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.12

Size of OTC and Exchange Markets


(Figure 1.2, Page 4)

Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.13

Forward Contracts
Forward contracts are similar to futures except that they trade in the over-thecounter market Forward contracts are popular on currencies and interest rates

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.14

Foreign Exchange Quotes for GBP on July 14, 2006 (See page 5)
Bid 1.8360 1.8372 1.8400 1.8438 Offer 1.8364 1.8377 1.8405 1.8444
1.15

Spot 1-month forward 3-month forward 6-month forward

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

Options
A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.16

American vs European Options


An American option can be exercised at any time during its life A European option can be exercised only at maturity

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.17

Intel Option Prices (Sept 12, 2006; Stock Price=19.56); See page 6
Calls Jan 2007 4.950 2.775 1.175 0.375 0.125 Puts Jan 2007 0.150 0.475 1.375 3.100 5.450

Strike Price ($) $15.00 $17.50 $20.00 $22.50 $25.00

Oct 2006 4.650 2.300 0.575 0.075 0.025

Apr 2007 5.150 3.150 1.650 0.725 0.275

Oct 2006 0.025 0.125 0.875 2.950 5.450

Apr 2007 0.275 0.725 1.700 3.300 5.450

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.18

Exchanges Trading Options


Chicago Board Options Exchange American Stock Exchange Philadelphia Stock Exchange International Securities Exchange Eurex (Europe) and many more (see list at end of book)

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.19

Options vs Futures/Forwards
A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.20

10

Three Reasons for Trading Derivatives: Hedging, Speculation, and Arbitrage


Hedge funds trade derivatives for all three reasons (See Business Snapshot 1.1) When a trader has a mandate to use derivatives for hedging or arbitrage, but then switches to speculation, large losses can result. (See Barings, Business Snapshot 1.2)
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.21

Hedging Examples (Example 1.1 and 1.2,


page 11)

A US company will pay 10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.22

11

Value of Microsoft Shares with and without Hedging (Fig 1.4, page 12)
40,000 Value of Holding ($)

35,000 No Hedging 30,000 Hedging

25,000 Stock Price ($) 20,000 20 25 30 35 40

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.23

Speculation Example (pages 14)


An investor with $2,000 to invest feels that Amazon.coms stock price will increase over the next 2 months. The current stock price is $20 and the price of a 2-month call option with a strike of $22.50 is $1 What are the alternative strategies?

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.24

12

Arbitrage Example (pages 15-16)


A stock price is quoted as 100 in London and $182 in New York The current exchange rate is 1.8500 What is the arbitrage opportunity?

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.25

1. Gold: An Arbitrage Opportunity?


Suppose that: The spot price of gold is US$600 The quoted 1-year futures price of gold is US$650 The 1-year US$ interest rate is 5% per annum No income or storage costs for gold Is there an arbitrage opportunity?
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.26

13

2. Gold: Another Arbitrage Opportunity?


Suppose that: The spot price of gold is US$600 The quoted 1-year futures price of gold is US$590 The 1-year US$ interest rate is 5% per annum No income or storage costs for gold Is there an arbitrage opportunity?
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.27

The Futures Price of Gold


If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) riskfree rate of interest. In our examples, S=600, T=1, and r=0.05 so that F = 600(1+0.05) = 630

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.28

14

1. Oil: An Arbitrage Opportunity?


Suppose that: The spot price of oil is US$70 The quoted 1-year futures price of oil is US$80 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity?
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.29

2. Oil: Another Arbitrage Opportunity?


Suppose that: The spot price of oil is US$70 The quoted 1-year futures price of oil is US$65 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum Is there an arbitrage opportunity?
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

1.30

15

Hedging Strategies Using Futures


Chapter 3

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.31

Long & Short Hedges


A long futures hedge is appropriate when you know you will purchase an asset in the future and want to lock in the price A short futures hedge is appropriate when you know you will sell an asset in the future & want to lock in the price

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.32

16

Arguments in Favor of Hedging

Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.33

Arguments against Hedging


Shareholders are usually well diversified and can make their own hedging decisions It may increase risk to hedge when competitors do not Explaining a situation where there is a loss on the hedge and a gain on the underlying can be difficult
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.34

17

Convergence of Futures to Spot


(Hedge initiated at time t1 and closed out at time t2)

Futures Price

Spot Price
Time t1 t2 3.35

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

Basis Risk
Basis is the difference between spot & futures Basis risk arises because of the uncertainty about the basis when the hedge is closed out

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.36

18

Long Hedge
Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future purchase of an asset by entering into a long futures contract Cost of Asset=S2 (F2 F1) = F1 + Basis
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.37

Short Hedge
Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future sale of an asset by entering into a short futures contract Price Realized=S2+ (F1 F2) = F1 + Basis
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.38

19

Choice of Contract
Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. There are then 2 components to basis
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.39

Optimal Hedge Ratio


Proportion of the exposure that should optimally be hedged is h= S F where S is the standard deviation of S, the change in the spot price during the hedging period, F is the standard deviation of F, the change in the futures price during the hedging period is the coefficient of correlation between S and F.
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.40

20

Hedging Using Index Futures


(Page 62)

To hedge the risk in a portfolio the number of contracts that should be shorted is P
F

where P is the value of the portfolio, is its beta, and F is the current value of one futures (=futures price times contract size)
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.41

Reasons for Hedging an Equity Portfolio


Desire to be out of the market for a short period of time. (Hedging may be cheaper than selling the portfolio and buying it back.) Desire to hedge systematic risk (Appropriate when you feel that you have picked stocks that will outpeform the market.)
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.42

21

Example
Futures price of S&P 500 is 1,000 Size of portfolio is $5 million Beta of portfolio is 1.5 One contract is on $250 times the index What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.43

Changing Beta
What position is necessary to reduce the beta of the portfolio to 0.75? What position is necessary to increase the beta of the portfolio to 2.0?

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.44

22

Rolling The Hedge Forward


We can use a series of futures contracts to increase the life of a hedge Each time we switch from 1 futures contract to another we incur a type of basis risk

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

3.45

Futures Options
Chapter 16

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Global Edition. Copyright John C. Hull 2010

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23

Background
The commodity Futures Trading Commission authorized the trading of options on futures on an experimental basis in 1982. Permanent trading wa approved in 1987. The popularity of the contract with investors has grown very fast.

Expiration Months
Futures options are referred to by the delivery month of the underlying futures contract---not by the expiration month of the option. Most futures options are American. The expiration date of a futures option contract is usually on, or a few days before, the earliest delivery date of the underlying futures contract.

24

Mechanics of Call Futures Options

When a call futures option is exercised the holder acquires


1. 2.

A long position in the futures A cash amount equal to the excess of the futures price at previous settlement over the strike price

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

49

Mechanics of Put Futures Option


When a put futures option is exercised the holder acquires
1. 2.

A short position in the futures A cash amount equal to the excess of the strike price over the futures price at previous settlement

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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25

The Payoffs
If the futures position is closed out immediately: Payoff from call = (previous Settlement price K)+(F previous settlement price F)=F-K Payoff from put = K F where F is futures price at time of exercise
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

51

Example 16.1 Mechanics of call futures options


An investor buys a July call futures option contract on gold. The contract size is 100 ounces. The strike price is 900. The investor exercises when the July gold futures price is 940 and the most recent settlement price is 938. The outcome The investor receives a cash amount equal to (938900)*100=$3,800 The investor receives a long futures contract. The investor closes out the long futures contract immediately for a gain of (940-938)*100=$200 Total payoff = $4,000

1.

2. 3.

4.

26

Example 16.2 Mechanics of put futures options


An investor buys a September put futures option contract on corn. The contract size is 5,000 bushels. The strike price is 300 cents. The investor exercises when the September corn futures price is 280 and the most recent settlement price is 279. The outcome The investor receives a cash amount equal to (3.002.79)*5,000=$1,050 The investor receives a short futures contract. The investor closes out the short futures contract immediately for a loss of (2.79-2.80)*5,000= -$50 Total payoff = $1,000

1.

2. 3.

4.

Potential Advantages of Futures Options over Spot Options


Futures contract may be easier to trade than underlying asset Exercise of the option does not lead to delivery of the underlying asset Futures options and futures usually trade in adjacent pits at exchange Futures options may entail lower transactions costs

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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27

European Spot Options and European Futures Options


The payoff from a European call option with strike price K on the spot price of an asset is
Max (ST - K,0), where ST is the spot price at the options maturity.

The payoff from a European all option with the same strike price on the futures price of the asset is
Max (FT - K, 0), where FT is the futures price at the options maturity.

If the futures contract matures at the same time as the option, then FT = ST, and the two options are equivalent.
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

55

Put-Call Parity for European Futures Options (Equation 16.1, page 347)
Consider the following two portfolios: A. a European call futures option plus Ke-rT of cash B. a European put futures option plus long futures contract plus cash equal to F0e-rT

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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28

Put-Call Parity for European Futures Options (Equation 16.1, page 347)
FT > K Portfolio A Call futures option Ke-rT Total Portfolio B Put futures option Long futures F0e-rT Total FT K K FT 0 (FT F0 ) F0 FT FT =< K 0 K K K FT (FT F0 ) F0 K

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

57

Put-Call Parity for European Futures Options (Equation 16.1, page 347)
Since portfolio A and portfolio B worth the same at time T, they should worth the same today. The value of portfolio A today is c+Ke-rT The value of portfolio B today is p+F0 e-rT Hence c+Ke-rT=p+F0 e-rT or c+(K-F0)e-rT=p

29

Bounds for European Futures Options


c+(K-F0)e-rT=p Because the price of a put or a call cannot be negative, it follows from the above equation that c > (F0 K)e-rT p > (K F0)e-rT

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

59

The Bounds for American Futures Options


F0 e-rT K < C P < F0 Ke-rT Because American futures options can be exercised at any time, we must have the following C > (F0 K) P > (K F0)

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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30

Binomial Tree Example


A 1-month call option on futures has a strike price of 29. Futures Price = $33 Option Price = $4 Futures price = $30 Option Price=? Futures Price = $28 Option Price = $0

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

61

Setting Up a Riskless Portfolio


Consider the Portfolio: long futures short 1 call option 3 4

-2

Portfolio is riskless when 3 4 = 2 or = 0.8

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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31

Valuing the Portfolio


( Risk-Free Rate is 6% )

The riskless portfolio is: long 0.8 futures short 1 call option The value of the portfolio in 1 month is 1.6 The value of the portfolio today is 1.6e 0.06/12 = 1.592
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

63

Valuing the Option


The portfolio that is long 0.8 futures short 1 option is worth 1.592 The value of the futures is zero The value of the option must therefore be 1.592
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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32

Generalization of Binomial Tree Example (Figure 16.2, page 349)


A derivative lasts for time T and is dependent on a futures F0u u F0d d
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

F0

65

Generalization
(continued)
Consider the portfolio that is long futures and short 1 derivative F0u F0 u F0d F0 d The portfolio is riskless when

u fd F0 u F0 d
66

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

33

Generalization
(continued)

Value of the portfolio at time T is F0u F0 u Value of portfolio today is Hence = [F0u F0 u]e-rT

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

67

Generalization
(continued)

Substituting for we obtain


= [ p u + (1 p )d ]erT

where

p=

1 d u d
68

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

34

Numerical Example
Consider previously example. u=33/30=1.1, d= 28/30=0.9333, 4=0.06, T=1/12, fu = 4, and fd = 0.
p= 1 0.9333 = 0 .4 1.1 0.9333

f = e 0.061 / 12 [0.4 4 + 0.6 0] = 1.592

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

69

Growth Rates For Futures Prices


A futures contract requires no initial investment. In a risk-neutral world the expected profit from holding a position in an investment that costs zero to set up must 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).
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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35

Valuing European Futures Options


We can use the formula for an option on a stock paying a continuous yield Set S0 = current futures price (F0) Set q = domestic risk-free rate (r ) Setting q = r ensures that the expected growth of F in a risk-neutral world is zero

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

71

A European Call and Put on a stock paying a dividend yield at rate q


The formulas is
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 = = d1 T T
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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36

Using Forward Prices


Define F0 as the forward price of the index for a contract with maturity T.
F0 = S 0 e ( r q )T c = F0 e rT N ( d 1 ) Ke rT N ( d 2 ) p = Ke rT N ( d 2 ) F0 e rT N ( d1 ) where d 1 = ln( S 0 / K ) + 2T / 2 T ln( S 0 / K ) 2T / 2 = d1 T d2 = T
73

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

Blacks Model
Compare equations on p.28 and equations on p.29, one clue could be derived. The two sets of equations are identical when we set q = r. Fischer Black was the first to show that European futures options can be valued using equations on p.28 with q = r and S0 replaced by F0.

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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Blacks Model
The formulas for European options on futures are known as Blacks model
c = e rT [F0 N ( d 1 ) K N ( d 2 ) ] p = e rT [K N ( d 2 ) F0 N ( d 1 ) ] d1 = d2 = ln( F0 / K ) + 2 T / 2 T T = d1 T
75

where

ln( F0 / K ) 2 T / 2

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

How Blacks Model is Used in Practice


European futures options 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

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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38

Valuation of a European futures option


Consider a European put futures option on crude oil. The time to the options maturity is four months, the current futures prices is $60, the exercise price is $60, the risk-free interest rate is 9% per annum, and the volatility of the futures price is 25% per annum. The put price is given by

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

77

Valuation of a European futures option (continued)


The put price p is $3.35.
d1 = ln( F0 / K ) + ( 2 / 2)T ln(60 / 60) + (0.252 / 2) (4 / 12) = = 0.07216 0.25 4 / 12 T

d 2 = d1 T = 0.07216 0.25 4 / 12 = 0.07216 N ( d1 ) = 0.4712 N ( d 2 ) = 0.5288 p = e 0.094 / 12 (60 0.5288 60 0.4712 ) = 3.35

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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39

Valuing a spot option using futures prices


Consider a 6-month European call option on spot gold 6-month futures price is 930, 6-month risk-free rate is 5%, strike price is 900, and volatility of futures price is 20% Value of option is given by Blacks model with F0=930, K=900, r=0.05, T=0.5, and s=0.2 It is 44.19

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

79

Valuing a spot option using futures prices (continued)


d1 = ln( F0 / K ) + ( 2 / 2)T ln(930 / 900) + (0.2 2 / 2) 0.5 = = 0.3026 T 0.2 0.5

d 2 = d1 T = 0.3026 0.2 0.5 = 0.1611 c = e 0.050.5 (930 N (0.3026) 900 N (0.1611) ) = $44.19

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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American Futures Option Prices vs American Spot Option Prices


If futures prices are higher than spot prices (normal market), an American call on futures is worth more than a similar American call on spot. An American put on futures is worth less than a similar American put on spot. When futures prices are lower than spot prices (inverted market) the reverse is true.
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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Futures Style Options (page 353-54)


A futures-style option is a futures contract on the option payoff Some exchanges trade these in preference to regular futures options The futures price for a call futures-style option is

F0 N (d1 ) KN (d 2 ) The futures price for a put futures-style option is


KN(d2 ) F0 N(d1)
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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Put-Call Parity Results: Summary


Nondividen d Paying Stock : c + K e rT = p + S 0 Indices : c + K e rT = p + S 0 e qT Foreign exchange : r T c + K e rT = p + S 0 e f Futures : c + K e rT = p + F0 e rT

Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

83

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 = r For futures, q = r
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010

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Mechanics of Options Markets


Chapter 8

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

8.85

Types of Options
A call is an option to buy A put is an option to sell A European option can be exercised only at the end of its life An American option can be exercised at any time

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

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Option Positions
Long call Long put Short call Short put

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

8.87

Long Call
(Figure 8.1, Page 186)

Profit from buying one European call option: option price = $5, strike price = $100. 30 Profit ($) 20 10 70 0 -5 80 90 100 Terminal stock price ($) 110 120 130
8.88

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

44

Short Call
(Figure 8.3, page 188)

Profit from writing one European call option: option price = $5, strike price = $100 Profit ($) 5 0 -10 -20 -30
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

110 120 130 70 80 90 100 Terminal stock price ($)

8.89

Long Put
(Figure 8.2, page 188)

Profit from buying a European put option: option price = $7, strike price = $70 30 Profit ($) 20 10 0 -7 40 50 60 70 80 Terminal stock price ($) 90 100

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

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Short Put
(Figure 8.4, page 189)

Profit from writing a European put option: option price = $7, strike price = $70 Profit ($) 7 0 -10 -20 -30
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

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50

60 70 80

Terminal stock price ($) 90 100

8.91

Payoffs from Options


What is the Option Position in Each Case?

K = Strike price, ST = Price of asset at maturity Payoff K Payoff K ST ST Payoff K ST


8.92

Payoff K ST

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Assets Underlying Exchange-Traded Options


Page 190-191

Stocks Foreign Currency Stock Indices Futures

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

8.93

Specification of Exchange-Traded Options


Expiration date Strike price European or American Call or Put (option class)

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Terminology
Moneyness : At-the-money option In-the-money option Out-of-the-money option

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

8.95

Terminology
(continued)

Option class Option series Intrinsic value Time value

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

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48

Dividends & Stock Splits


(Page 193-194)

Suppose you own N options with a strike price of K : No adjustments are made to the option terms for cash dividends When there is an n-for-m stock split, the strike price is reduced to mK/n the no. of options is increased to nN/m Stock dividends are handled in a manner similar to stock splits
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

8.97

Dividends & Stock Splits


(continued)

Consider a call option to buy 100 shares for $20/share How should terms be adjusted: for a 2-for-1 stock split? for a 5% stock dividend?

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Market Makers
Most exchanges use market makers to facilitate options trading A market maker quotes both bid and ask prices when requested The market maker does not know whether the individual requesting the quotes wants to buy or sell
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

8.99

Margins (Page 197-198)


Margins are required when options are sold For example when a naked call option is written the margin is the greater of: 1 A total of 100% of the proceeds of the sale plus 20% of the underlying share price less the amount (if any) by which the option is out of the money 2 A total of 100% of the proceeds of the sale plus 10% of the underlying share price

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Warrants
Warrants are options that are issued (or written) by a corporation or a financial institution The number of warrants outstanding is determined by the size of the original issue & changes only when they are exercised or when they expire
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

8.101

Warrants
(continued)

Warrants are traded in the same way as stocks The issuer settles up with the holder when a warrant is exercised When call warrants are issued by a corporation on its own stock, exercise will lead to new treasury stock being issued
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

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Executive Stock Options


Option issued by a company to executives When the option is exercised the company issues more stock Usually at-the-money when issued

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

8.103

Executive Stock Options continued


They become vested after a period of time (usually 1 to 4 years) They cannot be sold They often last for as long as 10 or 15 years Accounting standards are changing to require the expensing of executive stock options
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Convertible Bonds

Convertible bonds are regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratio

Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007

8.105

Convertible Bonds
(continued)

Very often a convertible is callable The call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose

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