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) 2 /
2
( ) / ln(
) 2 /
2
( ) / ln(
where
) ( ) (
) ( ) (
0
2
0
1
1 0 2
2 1 0
Alternative Formulas (page 353)
T q r
rT
rT
e S F
T d d
T
T K F
d
d N F d KN e p
d KN d N F e c
) (
/ ) / ln(
)] ( ) ( [
)] ( ) ( [
0 0
1 2
2
0
1
1 0 2
2 1 0
where
2
Options, Futures, and Other Derivatives, 8th Edition,
Copyright John C. Hull 2012
13
Valuing European I ndex Options
We can use the formula for an option on
an asset paying a dividend yield
Set S
0
= current index level
Set q = average dividend yield expected
during the life of the option
Options, Futures, and Other Derivatives, 8th Edition,
Copyright John C. Hull 2012
14
I mplied Forward Prices and
Dividend Yields
From European calls and puts with the same strike
price and time to maturity
These formulas allow term structures of forward prices
and dividend yields to be estimated
OTC European options are typically valued using the
forward prices (Estimates of q are not then required)
American options require the dividend yield term
structure
Options, Futures, and Other Derivatives, 8th Edition,
Copyright John C. Hull 2012
15
0
0
ln
1
) (
S
Ke p c
T
q e p c K F
rT
rT
The Binomial Model
Options, Futures, and Other Derivatives, 8th Edition,
Copyright John C. Hull 2012
16
S
0
u
u
S
0
d
d
S
0
f=e
-rT
[pf
u
+(1p)f
d
]
The Binomial Model continued
In a risk-neutral world the asset price
grows at rq rather than at r when there is
a dividend yield at rate q
The probability, p, of an up movement
must therefore satisfy
pS
0
u+(1p)S
0
d = S
0
e
(rq)T
so that
Options, Futures, and Other Derivatives, 8th Edition,
Copyright John C. Hull 2012
17
p
e d
u d
r q T
( )
Currency Options
Currency options trade on NASDAQ OMX
There also exists a very active over-the-
counter (OTC) market
Currency options are used by
corporations to buy insurance when they
have an FX exposure
Options, Futures, and Other Derivatives, 8th Edition,
Copyright John C. Hull 2012
18
Range Forward Contracts
Have the effect of ensuring that the exchange
rate paid or received will lie within a certain range
When currency is to be paid it involves selling a
put with strike K
1
and buying a call with strike K
2
(with K
2
> K
1
)
When currency is to be received it involves
buying a put with strike K
1
and selling a call with
strike K
2
Normally the price of the put equals the price of
the call
Options, Futures, and Other Derivatives, 8th Edition,
Copyright John C. Hull 2012
19
Range Forward Contract continued
Figure 16.1, page 348
Options, Futures, and Other Derivatives, 8th Edition,
Copyright John C. Hull 2012 20
Payoff
Asset
Price
K
1
K
2
Payoff
Asset
Price
K
1
K
2
Short
Position
Long
Position
The Foreign I nterest Rate
We denote the foreign interest rate by r
f
When a U.S. company buys one unit of the
foreign currency it has an investment of S
0
dollars
The return from investing at the foreign rate
is r
f
S
0
dollars
This shows that the foreign currency
provides a yield at rate r
f
Options, Futures, and Other Derivatives, 8th Edition,
Copyright John C. Hull 2012
21
Valuing European Currency
Options
A foreign currency is an asset that
provides a yield equal to r
f
We can use the formula for an option on
a stock paying a dividend yield :
S
0
= current exchange rate
q = r
Options, Futures, and Other Derivatives, 8th Edition,
Copyright John C. Hull 2012
22
Formulas for European Currency
Options (Equations 16.11 and 16.12, page 355)
Options, Futures, and Other Derivatives, 8th Edition,
Copyright John C. Hull 2012
23
T
T
f
r r K S
d
T
T
f
r r K S
d
d N e S d N Ke p
d N Ke d N e S c
T r
rT
rT
T r
f
f
) 2 /
2
( ) / ln(
) 2 /
2
( ) / ln(
where
) ( ) (
) ( ) (
0
2
0
1
1 0 2
2 1 0
Alternative Formulas (Equations 16.13 and 16.14)
Options, Futures, and Other Derivatives, 8th Edition,
Copyright John C. Hull 2012
24
F S e
r r T
f
0 0
( )
Using
T d d
T
T K F
d
d N F d KN e p
d KN d N F e c
rT
rT
1 2
2
0
1
1 0 2
2 1 0
2 / ) / ln(
)] ( ) ( [
)] ( ) ( [