LECTURE TEN

Options on stock indices

and
currencies
 Objectives
• Index options
– Portfolio beta
– Options on dividend paying stock
– Pricing index options
• Currency options
– Similarity with options on dividend paying index
– Binomial model adapted for dividends or interest
• Futures options
– Mechanics
– Binomial model
– Black’s model

2
 Options on stock indices
– The most popular underlying indices in the US are:
• S&P 100 (OEX and XEO)
• S&P 500 (SPX)
• Dow Jones Industrial Average (DJX) (times 0.01)
• Nasdaq-100 (NDX)

– In Australia, the ASX offers XJO Index Options that

have the S&P/ASX 200 Index as the underlying
asset

3
 Options on stock indices
– Index option contracts are on 100 times the index
– On the ASX, one XJO Index Option contract is on 10
times the index
– They are settled in cash
• The holder of a call option contract receives (S – K)x10 in
cash and the writer of the option pays this amount in cash
• The holder of a put option contract receives (K – S )x10 in
cash and the writer of the option pays this amount in cash
where:
S: the value of the index on the morning of the last trading date
K: the strike price

•
4
 Using index options for portfolio
insurance
– Suppose that the value of the index is S0 and the
strike price is K
– If a portfolio’s β is 1.0:
• The portfolio insurance is obtained by buying one put
option contract on the index for each 10S0 dollars in the
portfolio
– If the portfolio’s β is not 1.0:
• β put options must be purchased for each 10S0 dollars
in the portfolio
– In both cases, K is chosen to give the appropriate
insurance level
5
 Example 1
When the portfolio’s beta is 1.0
– A portfolio has a beta of 1.0 and is worth
$500,000
– The value of the S&P/ASX 200 index is 5,000

What trade is necessary to provide insurance against

the portfolio value dropping below $450,000?

6
 Example 1 Cont.
• The manager buys 10 put option contracts with a
strike price of 4500 on the S&P/ASX 200.
• If the index drops to 4400
• The value of the portfolio drops to $440,000
• So, there is a payoff of $10,000 (10*10*(4500-4400))
from the 10 put option contracts.

7
 Example 2
When the portfolio’s beta is not 1.0
– A portfolio has a beta of 2.0 and is worth $500,000
– The value of the S&P/ASX 200 index is 5,000
– The risk-free rate is 12% per annum
– The dividend yield on both the portfolio and the index
is 4%

What trade is necessary to provide insurance against the portfolio

value dropping below $450,000?
•How many put option contracts should be
purchased for portfolio insurance?
8
 Example 2 Cont.

• The strategy: buys 20 put option contracts with a strike

price of 4800.

• The outcome:
• If the index drops to 4400.
• The value of the portfolio drops to $370,000.
• There is a payoff of $80,000 from the 20 put option
contracts. This perfectly hedge the manager’s position:

• $370,000 + 80,000=$450,000.

9
 When the portfolio’s beta is not 1.0
Calculation of expected value of portfolio when the
index is 5,200 in three months and β = 2.0
Value of index in three months: 5,200
Return from change in index: 200/5,000, or 4% per three months
Dividends from index: 0.25 × 4 = 1% per three months
Total return from index: 4 + 1 = 5% per three months
Risk-free interest rate: 0.25 × 12 = 3% per three months

Excess return from index over risk-free interest rate: 5 – 3 = 2% per three months
Expected excess return from portfolio over risk-free
2 × 2 = 4% per three months
interest rate:
Expected return from portfolio: 3 + 4 = 7% per three months
Dividends from
Table 15.1, pageportfolio:
323 0.25 × 4 = 1% per three months
Expected increase in value of portfolio: 7 – 1 = 6% per three months
Expected value of portfolio: $500,000 × 1.06 = $530,000 10
When the portfolio’s beta is not 1.0
Relationship between value of index and value of portfolio for
β=2.0
Value of portfolio in three months
Value of index in three months ($)
5,400 570,000
5,200 530,000
5,000 490,000
4,800 450,000
4,600 410,000
4,400 370,000
Table 15.2, page 324

An option with a strike price of 4,800 will provide protection

against a 10% decline in the portfolio value ($500,000 -
$450,000).
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 Currency Options
– In the US:
• Currency options are primarily traded in the over-the-
counter market and are also traded on the NASDAQ
OMX
– In Australia:
• Currency options may be available in the over-the-
counter market
• Currency warrants are available on the ASX
– Currency options are used by corporations to
hedge a foreign exchange exposure

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 Range forwards
– A range-forward contract is a variation on a standard
forward contract for hedging foreign exchange risk
– They 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 price K1 and buying a call with strike price K2 .This is
known as long range-forward contract.
– When currency is to be received it involves buying a put
with strike price K1 and selling a call with strike price K2.
This is known as short range-forward contract.
– Normally the price of the put equals the price of the call .

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 Range forwards
• Payoffs from: (a) a short and (b) a long range-
forward contract

• Figure 15.1, page 326

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 Options on stocks paying known
dividend yields
– The payment of a dividend yield at rate q will
cause the growth rate in the stock price to be less
than it would otherwise be by an amount q.
– We get the same probability distribution for the
stock price at time T in each of the following
cases:
• The stock starts at price S0 and provides a dividend
yield q
• The stock starts at price S0e-qT and provides no income,
i.e., pays no dividends.

15
 Options on stocks paying known
dividend yields – The simple rule
– When valuing European options on a stock paying
known dividends we reduce the stock price from
S0 to S0e-qT and then value the option as though
there is no dividend

16
 Lower bounds for option prices
The lower bound for a European call option price, c, is
given by: c ≥ S e-qT − Ke-rT
0

The lower bound for a European put option, p, is given

by:

p ≥ Ke-rT − S0e-qT

17
 Put–call parity
•The put–call parity for a European option on a
stock paying a dividend yield of q is:
c + Ke-rT = p + S0e-qT
•
• For American options, the put–call parity
relationship is:

S0e-qT - K ≤ C - P ≤ S0 - Ke-rT

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 Pricing formulas
• c = S0e-qT N(d1) - Ke-rT N(d2)
•
p = Ke-rT N(-d2) - S0e-qT N(-d1)
• where:

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 Valuation of European stock index
options
• Index options could be treated as an asset
paying a known yield.
– Set:
• S0: the value of the index
• σ: the volatility of the index
• q: the average annualised dividend yield on the index
during the life of the option

20
 Example 15.3
•Consider a European call option on the
S&P/ASX 200 that is two months from maturity.
•S0 = 4,650; K = 4,500; r = 0.08; σ = 0.2; T = 2/12;
dividend yields of 0.2% and 0.3% are expected in
the first month and the second month,
respectively.

•How much would one contract cost?

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 SOLUTION TO EXAMPLE 15.3
ln( 4650 / 4500)  (0.08  0.03  0.22 / 2)  2 / 12
d1   0.5445
0.2 2 / 12
ln( 4650 / 4500)  (0.08  0.03  0.22 / 2)  2 / 12
d2   0.4628
0.2 2 / 12

So that the call price, c, is given by eqn. 15.4 as:

N d1   0.7070, N d 2   0.6782

c  4650  0.7070 e ( 0.03)( 2 /12)  4500  0.6782 e ( 0.08)( 2 /12)  259.675
So, one contract would cost $259.675
 Using forward prices
• Define: F0 = S0e(r-q)T
• So that: c = F0e-rT N(d1) - Ke-rT N(d2)

p = Ke-rT N(-d2) - F0e-rT N(-d1)

• where:
ln(F /K) σ 2
T/2
d1  0
σ T
ln(F /K) σ 2
T/2
d2  0
σ T
23
 Valuation of European currency
options
– We denote:
• the spot exchange rate by S0
• the foreign interest rate by rf
– The return measured in the domestic currency
from investing in the foreign currency is rf times
the value of the investment
– This shows that the foreign currency provides a
yield at rate rf

24
 Valuation of European currency
options
With q replaced by rf, the bounds for the European call
price and the European put price are:
−r f T −rT
𝑐 ≥ 𝑆0 e − 𝐾e

𝑝 ≥ 𝐾e−rT − 𝑆0 e−r f T

The put–call parity for European currency options

is:
𝑐 + 𝐾e−rT = 𝑝 + 𝑆0 e−r f T
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 The pricing formulas for European
currency options
 rf T
cS0e N (d1 )Ke rT N (d 2 )

rT rf T
pKe N (d2 )S0e N (d1 )

ln( S0 / K )( rrf  2 /2)T

• where: d1
 T
ln( S0 / K )( rrf  2 /2)T
d2 
 T
26
 Using forward exchange rates
( rrf )T
• Using: F0 S0e

ce  rT [ F0 N ( d1 )KN ( d 2 )]
• Then:
pe rT [ KN ( d 2 )F0 N ( d1 )]

ln( F0 / K ) 2T /2
d1 
 T
• where:
ln( F0 / K ) 2T /2
d2
 T
27
 American options
The binomial model
•For a non-dividend-paying stock, the probability of
an up movement is:
𝑎−𝑑
𝑝=
𝑢−𝑑

• Where 𝑎 = 𝑒 𝑟∆𝑇

• For options on index. 𝑎 = 𝑒 (𝑟−𝑞)∆𝑇

• For options on currency. 𝑎 = e(𝑟−𝑟 𝑓 )∆T

28
 Nature of futures options
– A futures option is the right, but not the obligation, to
enter into a futures contract at a certain futures price
by a certain date.
– A call (put) futures option is the right to enter into a
long (short) futures contract at a certain price.
– Futures options are generally American; that is, they
can be exercised at any time during the life of the
contract
– The expiration date is usually on, or a few days before,
the earliest delivery date of the underlying futures
contract

29
Mechanics of call futures option
– When a call futures option is exercised the holder
acquires:

• A long position in the futures

• A cash amount equal to the excess futures price at time
of exercise over the strike price

– An investor who sells (or writes) a call futures

option receives the option premium and take the
risk that the contract will be exercised.

30
 Mechanics of call futures option-
Example 16.1
• An investor buys a July call futures option contract on
gold. The contract size is 100 ounces. The strike price is
900.
• The exercise decision:
The investor exercises the July gold futures price is 940
and the most recent settlement price is 938.
• Outcome for investor:
– Receives a cash amount = (938-900) * 100 = $3,800.
– Receives a long futures contract.
– Closes out the long futures contract immediately for a gain
of (940-938)*100 = $200.
– Total payoff = $4,000.
Mechanics of put futures option
– When a put futures option is exercised the holder
acquires:
• A short position in the futures
• A cash amount equal to the excess of the strike price
over the futures price at the time of exercise

– The writer of a put futures option obtains a long

futures position and the excess of the strike price
over the most recent settlement price.

32
 Mechanics of put futures options
• An investor buys a September put futures options
contract on corn. The contract size is 5,000 bushels.
The strike price is 300 cents.
• Exercise decision:
• The investor exercises when the September corn
futures price is 280 and the most recent settlement
price is 279.
• The outcome:
– Receives (3.00 – 2.79 )*5000=1050.
– Receives a short futures contract.
– Closes out the short futures position immediately for a loss
of (2.80-2.79)*5000 = $50.
– Total payoff = $1,000.
 The payoffs
If the futures position is closed out immediately:
• Payoff from call = F – K
• Payoff from put = K – F

where:
F: futures price at time of exercise
K: strike price

34
Reasons for the popularity of futures
options
– Futures contracts are more liquid and easier to
trade
– Futures price is known immediately from trading
on the futures exchange
– Exercise of the futures option does not lead to
delivery of the underlying asset
– Futures options and futures are traded in pits side
by side in the same exchange
– Futures options entail lower transactions costs

35
European spot and futures options
The payoff from a European call option with strike price
K on the spot price of an asset:

Max(ST - K, 0)
•
•The payoff from a European call option with the
same strike price on the futures price of the
asset:
Max(FT - K, 0)

36
 Put–call parity
• Consider the following two portfolios:
– European call futures option plus an amount of cash
equal to Ke-rT
– European put futures option plus a long futures
contract plus an amount of cash equal to F0e-rT to.
•It can be shown the value of both portfolios is equal
to max (FT, K) at time T. Therefore:

c+ Ke-rT =p+F0e-rT

37
 Put–call parity for American futures
options
• The relationship is:
•

F0e-rT – K < C – P < F0 - Ke-rT

•

38
 Bounds for futures options
• European:
• c ≥ (F0 – K)e-rT
• p ≥ (K - F0)e-rT
•
• American:

C ≥ F0 – K
p ≥ K - F0

39
 Valuation of futures options using
binomial trees
• A one-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

40
 Setting up a riskless hedge
– Consider a portfolio:
• Short position in one options contract
• Long position in Δ futures contracts

3Δ–4

-2Δ
– Portfolio is riskless when 3 Δ – 4 = -2Δ or Δ = 0.8

•What is the value of the portfolio today assuming r=.06?

•
41
 Valuing the portfolio
– The riskless portfolio consists of:
• One short option
• Δ long futures contracts
– The value of the portfolio in one month = –1.6
– The value of the portfolio today:
–1.6e-0.06*1/12 = –1.592
– Since the value of the futures contract today is
zero, the value of the option today must be 1.592

42
 Generalisation example
• Futures price and option price in the
general situation

Figure 16.2, page 345

43
 Generalisation example (cont.)
• Consider the portfolio that is long D futures
and short one option
F0u D  F0 D – ƒu

F0d D F0D – ƒd
. The portfolio is riskless when:
ƒ u f d
Δ
F0 u F0 d
44
 Generalisation example (cont.)
• Value of the portfolio at time T is always:
(F0u - F0)∆ – ƒu

• Value of the portfolio today:

[(F0u - F0)∆ – ƒu]e-rT

• The present value of the portfolio:

-f = [(F0u - F0)∆ – ƒu]e-rT
45
 Generalisation example (cont.)
• Substituting for Δ and simplifying reduces this
equation to:
• f = e-rT [pfu + (1 – p) fd)]
•
• where:

1 d
p
u d

46
 Example in slide 40 - revisited
• U =1.1; d=0.9333; r =0.06; T=1/12; fu=4; fd=0.

1 d 1  0.9333
p    0.4
u  d 1.1  0.9333

f = e-0.06* 1/12 [0.4*4 + (1 – 0.4)*0]= 1.592

A futures price as an asset providing a
yield
– Futures prices behave in the same way as a stock
paying a dividend yield q equal to the domestic
risk-free rate r

•
•

48
A futures price as an asset providing a
yield
– A futures contract requires zero investment
– In a risk-neutral world the expected profit must be
zero
– The expected payoff from a futures contract must
therefore be zero
– The expected growth rate of the futures price
must be zero
– The futures price can therefore be treated like a
stock paying a dividend yield of r

49
 Black’s model for valuing futures
options
• Formulas for European options on futures are
known as Black’s model.

c e
 rT
F
0 N(d 1 )K N(d 2 )

p  e  rT K N( d2 )  F0 N( d1 )

• where:
ln(F0 /K)  σ 2T/2
d1 
σ T

ln(F0 /K)  σ 2T/2

d2   d1  σ T
σ T
50
 Example 16.4
• Consider a European put futures option on crude
oil. The time to the option’s maturity is four
months, the current futures price 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.

F0= 60, K=60, r=0.09,T=4/12, σ=0.25 and

ln(F0/K)=0.

• What is the put price?

 What is the put price? (Example 16.4)

 T
d1   0.07217
2

 T
d2     0.07217
2
N  d1   0.4712, N  d 2   0.5288

p  e 0.094 /12 60  0.5288  60  0.4712  3.35 or $3.35

 Using Black’s model instead of
the Black–Scholes–Merton model
– Black’s model provides a way of calculating the
value of European options on the spot price of an
asset
– Example 16.5:
• A 6-month European call option on the spot price of
gold
• K = $900, F0 = $930, r = 0.05, T = 0.5, and σ = 0.2

What is the value of the option?

53
 Example 16.5
The value of the option is given by equation 16.7
as:

c  e  rT F0 N d1   KN d 2 

ln 930 / 900   0.2  0.5 / 2

d1   0.3026
0.2  0.5
ln 930 / 900   0.2  0.5 / 2
d2   0.1611
0.2  0.5
Therefore,
c  e  0.050.5 930 N d1   900 N d 2 
American futures options vs. American
spot options
– If futures prices are higher than spot prices:
• an American call futures option is worth more than the
corresponding American spot call option
• an American put on futures is worth less than the
corresponding American spot put option

– When futures prices are lower than spot prices

the reverse is true

55
 Futures-style options
– Futures-style options are futures contracts on the
option payoff
– Some exchanges trade futures-style options in
preference to regular futures options
– The futures price in a call futures-style option is:

F0 N ( d1 )KN ( d 2 )
– The futures price in a put futures-style option is:

KN ( d 2 )F0 N ( d1 )
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 Put-call parity results: Summary
• Non-dividend paying stock:
c K e rT p S0
• Indices:
c K e rT p S0 e qT

• Foreign exchange:
c K e rT p S0 e rfT
• Futures:
c K e rT p F0 e rT
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