Futures and Options

Futures

Futures
Exchange traded so counter party risk is eliminated
Standardization of size, delivery and price.
Delink delivery and price
Flexibility to exit

Contract month : month in which delivery is to be made

Trading unit : standard contract size that will be traded on an
exchange
Contract multiplier
Price quotation : basis of price
Tick size : minimum change that will be recognized in price quotation
 Futures

Price limits
Delivery centers
Additional delivery centres
Delivery period
Quality allowance
Margin requirements: exchange specified margin , as a % of
contract value based on volatility of underlying asset
Initial margin
Maintenance margin margin call
Additional margin
Marking to market : settlement of price on a daily basis.
 Other derivatives

Example of MTM
Day Price Cash flow Remark
Day 1 410 None Long position of 400 shares
valued at 164,000
Close day 420 (420-410) 400 = + Investor receives 4000
1 4000
Close day 400 (400-420) 400 = - Investor pays 8000
2 8000
Close day 390 (390-400) 400 = - Investors pays 4000
3 4000
Exit day 4 440 (440-390) 400 = Position closed with contract
+20000 value of 176,000. Investor
gets 20000
Net profit (440-410) 400 = +
12000
 Futures

Some key terminology

Long position : Buying a future
Short position : Selling a future
Opening a position : Buying / selling a future.
Closing a position : Buying / Selling a future ( of same underlying
asset and period ) if you have sold / bought earlier
Open position
Naked , Calendar spreads
Position calculation
Open interest : Number of contracts outstanding at any point in time
Volume
One side
Two sides
 Futures

Futures settlement
Thru cash
Physical delivery

Whether a settlement is by cash / physical delivery is determined by

Can it be settled physically ?
Will exchange be interested
Will exchange have required infrastructure
Regulatory requirements
Stock : Cash settled
Commodity : Physically settled

3 types of contract
Compulsory delivery contracts gold
Intention matching contracts oil
Sellers option contract Agricultural goods
 Futures

Settlement
Cash settlement
All open positions marked to market on maturity day of contract
Settlement price of the futures contract is settlement price of underlying
assets in cash market

Physical settlement
Actual delivery within the delivery period after expiry of contract
Prices paid by buyer is futures settlement price on the day previous to
expiry date.
Why ?
 Futures

When will a futures contract be successful :

Liquidity
Right contract size
Regulatory framework

Purposes of futures market

Price discovery
Hedging
Anticipatory hedging
Example :
Portfolio : 8 lakhs , beta of portfolio : 1.5
Risk that market falls by 10% in 1 month
Possibility :
Sell cash, buy later
Hold cash, sell futures
Hedge ratio : Vp x Beta p /V ind
 Futures

Futures price :
Spread
Difference between two futures prices
Intra commodity spread
Inter commodity spread
Basis
Basis = Current cash price futures price
Positive basis
Negative basis
Cash price in a particular location
Futures price nearby futures contract
Normal market : prices of more distant futures higher than nearby futures
Inverted market : prices of more distant futures lower than nearby futures
 Futures

F > C : contango market

F < C : backwardation market

Convergence of futures and spot prices

Pricing futures
Cost of carry model
Expectation model
 Futures

Cash and futures pricing relationship :

Example :
Spot : 400
Futures : 450
Interest rate : 10%
Transaction : t (0)
Borrow 400 at 10 % ,
Buy spot for 400 ,
Sell futures for delivery at 450 in one year
Total cash flow at t (0) = 0
Transaction : t ( 1)
Deliver asset against futures market at 450
Repay loan ,including interest ( 400 + 10% ) = 440
Total cashflow at t (1) = 10
Cash and carry arbitrage transaction
 Futures

Cash and futures pricing relationship :

Example :
Spot : 420
Futures : 450
Interest rate : 10%
Transaction : t (0)
Sell spot : 420
Lend 420 at 10 %
Buy futures for delivery in one year
Total cash flow at t (0) = 0
Transaction : t ( 1)
Collect proceeds from loan : ( 420 + 42) = 462
Accept delivery on futures contract : 450
Total cashflow at t (1) = 12
Reverse cash and carry arbitrage transaction
 Futures

1) To prevent cash and carry arbitrage : F (0,t) S (0) ( 1 + C)

2) To prevent reverse cash and carry arbitrage : F (0,t) S (0) ( 1 + C)

Where :
F is futures price
S is spot price
C is cost of carry
o is current time
t is time

Hence
F (0,t) = S (0) ( 1 + C)
 Futures

Spreads and cost of carry :

Example :
Futures price one year : 400 , Futures price two years : 450 , Interest rate : 10 % pa
Transactions t (0)
Buy futures expiring one year, sell futures expiring in two years, contract to borrow
400 at 10% from year 1 to year 2
Cash flow : 0
Transaction t (1)
Borrow 400 for 1 year at 10% ( as contracted in t(0)), take delivery of futures (
-400), store asset for one year
Cash flow : 0
Transaction t (2)
Deliver asset to honor futures : 450
Repay loan ( 400 + 40) = - 440,
Cash flow : 10
Forward cash and carry arbitrage
 Futures

Spreads and cost of carry :

Example :
Futures price one year : 440 , Futures price two years : 450 , Interest rate : 10 %
pa
Transactions t (0)
Sell futures expiring one year, buy futures expiring in two years, contract to lend
440 at 10% from year 1 to year 2
Cash flow : 0
Transaction t (1)
Borrow asset for one year
Deliver against expiring future : 440 , Invest proceeds from delivery for 1 year :
440 :
Cash flow : 0
Transaction t (2)
Accept delivery of expiring future : - 450, return asset , collect loan made ( 440
+44) : total cash flow : 34
Forward reverse cash and carry arbitrage
 Futures

1) To prevent forward cash and carry arbitrage : F (0,d) F(o,n) ( 1 + C) , d >n

2) To prevent forward reverse cash and carry arbitrage :F (0,d) F(o,n) ( 1 + C) , d >n

Hence
F (0,d) = F(o,n) ( 1 + C) , d >n

Where , F (0,d) is the value of distant month future contract

And is F(o,n) the value of the near month future contract
And C is the cost of carry

Implied repo rate : from the futures price and spot price, one can determine the
implied repo rate or the implied cost of carry.
C = [ F (0,t) / S (0) ] 1

If an entities actual borrowing cost is less than the implied cost of carry, it is
possible for that entity to arbitrage and take advantage.
 Futures

Impact of transaction costs :

Spot 400, futures 450, interest rate 10 %, transaction costs 3 %

Transaction : t (0)
Borrow 412 for 1 year @ 10 %, use to buy asset in spot for 400 and
pay transaction costs ( - 412) , sell futures for 450 one year down
the line :
Outflow = 0
Transaction : t ( 1)
Deliver asset in futures market : + 450
Repay loan , including interest : 453.20
Net loss : 3.20
 Futures

Impact of transaction costs :

Spot 420, futures 450, interest rate 10 %, transaction costs 3 %

Transaction : t (0)
Sell asset short paying 3 % transaction costs : + 407.40 ( 420 x 0.97)
Lend 407.40 for one year at 10%
Buy futures for delivery in one year :
Outflow = 0
Transaction : t ( 1)
Collect loan proceeds : ( 407.40 x 1.1) = 448.14
Accept asset from futures = - 450
Use it to settle short sale = 0
Cash flow = - 1.86
 Futures

1) To breakeven : F (0,t) S (0) ( 1 + T) ( 1 + C)

2) To breakeven : F (0,t) S (0) ( 1 T) ( 1 + C)
So ,
S (0) ( 1 + T) ( 1 + C) F (0,t) S (0) ( 1 T) ( 1 + C)

No arbitrage bounds
Example :
Spot 400, Interest cost 10%, Transaction costs 3 %
No arbitrage futures price , in perfect markets
F (0,t) S (0) ( 1 + C) = 400 x 1.1 = 440
Upper no-arbitrage price with transaction costs
F (0,t) S (0) ( 1 + T) ( 1 + C) = 400 x 1.03 x 1.1 = 453.20
Lower no arbitrage price with transaction costs
F (0,t) S (0) ( 1 T) ( 1 + C) = 400 x 0.97 x 1.1 = 426.80
 Futures

In some cases, there may be cashflow from the underlying asset for
instance, dividend from a stock. Then, if rate of carrying , rate of inflow is
known, then,

Future prices = cash price (S) + cost of carry ( r) any inflows (q)

F = S ( 1 + r q) t

Considering continuous compounding

F=Se (r-q)x t

Example :
If Spot is Rs 2000, r is 10% pa, q is 3 % and t is one month what can F be ?
 Futures

Limitations of cost of carry model

Direct transaction costs
Unequal borrowing and lending costs
Restrictions on short selling
Limitations on storing
-----
Expectations model
In markets for agricultural /seasonal commodities, the expectations
model explains futures prices better.

F (0,t) E (0) ( S (t))

 Options

Options
Confers a right , but creates no obligation to perform

Call option : right but no obligation to buy an asset at a predetermined

price within the specified time
Put option : right but no obligation to sell an asset at a predetermined
price within the specified time

Buyer or holder
Writer or seller
Premium
Strike price
Expiry date / maturity date
European option exercised only upon maturity
American option exercised at any time before maturity
 Options

Options
Assume A buys a right from B to buy ( call option)
to buy an asset at Rs 7000 (strike price) ,
for settlement in 1 month ( exercise date)
by paying Rs 300 ( premium)
Underlying asset is trading at Rs 7000 ( cash price)
Pay off for call option buy

Profit zone
Profit
or
loss Asset price
700 730
0 0
300 Loss zone
 Options

Options
Assume A buys a right from B to buy ( call option)
Bs position

Pay off for call option sel

300 Profit zone

Profit Asset price

or 700 730
loss 0 0
Loss zone
 Options

Options
Assume A buys a right from B to sell ( put option)
to sell an asset at Rs 7000 (strike price) ,
for settlement in 1 month ( exercise date)
by paying Rs 300 ( premium)
Underlying asset is trading at Rs 7000 ( cash price)
Pay off for put option buy

Profit zone
Profit
or 670
loss 0 Asset price
700
0
300 Loss zone
 Options

Options
Assume A buys a right from B to sell ( put option)
Bs position

Pay off for put option sel

Profit zone
Profit
or 670
loss 0 Asset price
700
0
300 Loss zone
 Options

Options
Relationship between strike price of option and Market price of
asset
Market scenario Call option Put option
Market price > strike In-the-money Out-of- money
price The call can be exercised Put will not be exercised, as
Market price = 150 to make a gain of 50 the asset can be sold in the
Strike price = 100 market
Market price < strike Out-of-money In-the-money
price Call will not be exercised Put can be exercised to
Market price = 100 as it is cheaper to buy in make a gain of 50
Strike price = 150 the market
Market price = strike At-the-money At-the-money
price
Market price strike Near-the-money Near-the-money
price
 Options

Pricing : Maximum and minimum prices for options : Call options

Upper bound : price of a call option ( C) can never exceed the current price
S of the underlying asset
CSt
Lower bound
C0
For American call options, price of call should be equal to immediate
exercise price the strike price

C A StK

For European call options, price of call should be equal to immediate

exercise price the PV of the strike price
C E S t PV( K)

Also , as American options entail more flexibility , C A C E

C = Call premium S t = Current Spot price

T = Time until expiration K = strike price
 Options

Maximum and minimum prices for options : call options

Hence :
Current price is the upper bound for any call

C St
For European calls

C E max ( 0, S t PV( K) )
For American calls

C A max ( 0, S t K , S t PV( K) )
 Options

Maximum and minimum prices for options : Put options

Upper bound : the maximum pay off from holding a put option is the strike
price (assuming asset does not become negative) . Hence, upper bound is
PK
Lower bound
P0
For American put options, price of put should be equal to immediate exercise
price
PA K-St

For European put options, price of putl should be equal to

P E PV( K) - S t

Also, P A P E

P = Put premium S t = Current stock price

T = Time until expiration K = strike price
 Options

Maximum and minimum prices for options : put options

Hence :
Current price is the upper bound for any put

P K
For European puts

P E max ( 0, PV (K) - S t )
For American puts

P A max ( 0, K - S t , PV (K) - S t )
 Options

Is there an relationship between call prices and put prices ?

Put call parity : European

Let us consider the following two situations A and B
A : Long one call, Investment of PV ( K) for maturity at T
B: Long one put, Long one unit of asset

Portfolio value at T
Initial cost If S < K If S K
A CE + PV ( K) 0+K=K SK+K=
S
B
Therefore, P E+ S K S+ S = K 0 + S = S

C E + PV ( K ) = P E +S.

This gives the relationship between put prices and call prices. Hence, if one were to know the
Call prices, strike price, risk free rate, time to maturity and the spot prices, one can
calculate the Put premiums.
 Options

Components of the option premium

We will consider the first component , called the insurance value of an option :
Holding an option provides protection against unfavorable price movements .
Value of protection is the insurance value of an option

We had seen that C S t PV( K)

So, Insurance value of the option , IV ( C) = C ( S t PV( K) )

Or C = S t PV( K) + IV ( C)

Adding and subtracting K to the RHS

C = (S t K ) + ( K PV( K)) + IV ( C) .

We now have the three components ,

1. (S t K ) : Intrinsic value of a call option
2. ( K PV( K)) : Time value of a call option
3. IV ( C) : insurance value of a call option
 Options

Similarly for a put option

In a call, we pay strike
We had seen P E PV( K) - S t
price upon exercise, but
in a put, we receive the
So, IV ( P) = P (PV( K) - S t ) strike price upon exercise.
So, while the time value
Or : of a call is positive (there
IV ( P) = P PV( K) + S t
are interest savings from
P = PV ( K ) - S t + IV ( P) deferred purchase), that
Adding and subtracting K to the RHS of a put is negative
( there are interest losses
P = (K - S t) - ( K PV( K)) + IV ( P ) from deferred sale).
This will also explain the
1. (K - S t ) : Intrinsic value of a put option
impact of interest rates
2. - ( K PV( K)) : Time value of a put option
3. IV ( C) : insurance value of an option
on premiums
 Options

Some more info on the following :

Intrinsic value of options
Time value of options

Intrinsic value
= amount by which the option is in-the-money
= amount an option buyer will realize before adjusting the premium, if he exercises the
option
= amount an option seller will lose
In the money options have intrinsic value
Out of money, at the money options have no intrinsic value
Intrinsic value can never be negative
Call option intrinsic value = Max ( 0, S t K )
Put option intrinsic value = Max ( 0, K - S t )
 Options

Time value
= extrinsic value
= takes care of future risk for seller of option
= quantification of the probability of an out-of-the-money , or
at-the-money contract going in-the-money , or , an existing
in-the-money contract going deeper in-the-money.
Depends on time to expiration and volatility of asset
Time value of option = Option premium intrinsic value
For out of money, at the money contracts , Entire option
premium = time value of option.
 Options
Option premium
Time value
Maximum for at the money contracts, as high uncertainty of price movements

Strike price

In the money At the money Out of money

Value of option at maturity = intrinsic value
Time value of option decreases at accelerated pace during last phase of its life
When option is deep-in the money / deep out of money, price intrinsic value
 Options

Factors that determine price of option

Cash price / Spot price : S t

Exercise price : K
Volatility of underlying asset :
Risk free rate : r
Time left for expiration T
Dividend yields ( if any)
 Options

The impact of various factors on call and put premiums

Factors Call Put option Explanations

option
Cash price (S t ) Increase Decrease Obvious
Strike price ( K) Decrease Increase Obvious
Volatility ( ) Increase Increase Obvious
Time to expiration ( Increase Increase Obvious
T)
Interest rate ( r) Increase Decrease Already
explained
 Options
Black Scholes Model for pricing call option :
There are only 5
C = S t ( risk factor 1) - PV (K) ( risk factor 2)
variables S, K, r, t, and

C = S t N ( d 1) K e ( -r t) N (d 2) . 1 Of these K and t are
contract variables.
S and r are market
P = PV (K ) ( risk factor 2) - S t ( risk factor 1)variables and only is
not directly observed.
P=Ke ( -r t) N (- d 2) - S t N (- d 1) . 2
C = Call premium r = risk free rate
P = Put premium N ( . ) = cumulative normal distribution
function
S t = Current stock e = exponential term ( 2.7813)
price
t = Time until
expiration
K = strike price
 Options

Assumptions that go into the model :

Main assumption :
Asset price evolves according to geometric Brownian motion
(Or in other words , that the returns of an asset over any holding period
have a log normal distribution with mean and constant volatility :
i.e. if S0 is the current asset price and St is the price of the asset at time
t, then,
ln ( St / S0) ~ N (t , 2 t)
Others :
i. Risk free rate r is constant
ii. No dividends of interim cashflows from the underlying asset
iii. All options are European in style , maturing at t and strike price K
iv. Markets are efficient
v. No commissions are charged
 Options

Example :
3 month call option
Strike : 1180
Spot : 1150
Volatility : 30% per annum
Risk free rate is 12 %

What is C ? =

What is P is derived from call price, using put call parity

 Options

Introduction of new option contracts :

Exchanges introduce 7 options per underlying , 3 ITM, 1 ATM, 3
OTM

Settlement of Option contracts

Delivery based , non delivery based.
Assignment of options

1. System will check for all open long positions ( A) & total exercised
positions (B) for each series
2. If A = B, then for all sellers, Assigned position= short position
3. If B < A, it is randomly assigned.
 Options

Risk management in Option market

Risk of buyer defaulting : Nil

Risk of seller defaulting
Futures style options
MTM passed on
Premium style options
MTM retained
 Options

Binomial model
Consider
Current price of an asset (S) is Rs 20
It is known that the at the end of 3 months ( T), the price will be either Rs
22 (Su) , or Rs 18 ( S d) . We see that u > 1, and d < 1
Consider that we buy a European call option to buy the asset at Rs 21 ( K)
If the asset price turns out to be Rs 22, the value of the option will be Rs 1 ( f
u)

If the asset price turns out to be Rs 18, the value of the option will be Rs 0 ( f
d)

Where percentage increase in asset price in an

Suup
Rsmovement is u 1 , and
percentage decrease in asset price in down movement is 1- d
22
S , Rs 20 f u = Rs
1
Sd = Rs 18
f d = Rs 0
 Options

Binomial model
We set up a portfolio of the asset and an option where there is no uncertainty
about the value of the portfolio at the end of 3 months.
As the portfolio has no risk, the return it earns must be equal to risk free return (r)
Go long on units of asset and short one call option, such that the value of is
such that the portfolio becomes riskless
If value of asset moves from Rs 20 to Rs 22, the value of assets is 22 and the
value of option is Rs 1. So total value of portfolio is 22 1
If value of asset moves from Rs 20 to Rs 18, the value of assets is 18 and the
value of the option is Rs 0 . So the total value of portfolio is 18 . Hence
22 1 = 18 , i.e., = 0.25
Or
Su fu = Sd f d
Or : = ( f u f d ) / (Su Sd )
 Options
Binomial model
A riskless portfolio hence has long of 0.25 units of asset and short of 1 option
If price moves to Rs 22, value of the portfolio = 22 x 0.25 1 = 4.5
If price moves to Rs 18, value of the portfolio = 18 x 0.25 = 4.5
Riskless portfolios must earn riskfree rate of interest. Suppose risk free rate is 12 %.
The value of portfolio today must hence be the PV ( 4.5) or
4.5 e -0.12 x 3/12 = 4.367
The value of the asset is Rs 20. Suppose the option price is denoted by f, the value of the
portfolio is today
20 x 0.25 f = 5 f.
Hence
5 f = 4.367 , or f = 0.633
If the value of option is more than 0.633 , it would cost less than 4.367 to set up, and earn
a return more than risk free rate
If the value of option is less than 0.633, we can short the portfolio, giving us an way to
borrow money at less than risk free rate.
 Options
Binomial model
Generalizing this,
=(f u f d ) / (Su Sd )
The portfolio has to earn a risk free rate . The present value of the portfolio is
(Su f u) e rt
The cost of setting the portfolio is S f.
Hence
S f = (Su f u) e rt
or
f = S ( 1 ue rt)+ f u e rt
Substituting for , we have
f= S x (( f u f d ) / (Su Sd ) ) ( 1 ue rt)+ f u e rt

f=f u ( 1 de rt ) + ( ue rt 1 ) / u d
f = e rt ( p f u + ( 1 p) f d ),
Where
p = e rt d / u- d
 Options
Binomial model
Getting back to the example , we know
u = 1.1
d = 0.9 ,
r = 12 % ,
t = 3/12 = 0.25)
f u = 1 and f d = 0
We know p = e rt d / u- d
Substituting , we have
p= e 0.12 x 3/12 0.9 / 1.1 0.9 = 0.6523

Substituting p in the equation f = e rt ( p f u + ( 1 p) f d )

We have f = e 0.12 x 3/12 ( 0.6523 x 1 + ( 1 0.6523 ) x 0 ) = 0.633