Fundamentals of Futures and Options: Roger G. Clarke, Harindra de Silva, CFA, Steven Thorley, CFA

FUNDAMENTALS OF
FUTURES AND OPTIONS
Roger G. Clarke, Harindra de Silva, CFA, Steven Thorley, CFA

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Roger G. Clarke
Analytic Investors
Harindra de Silva, CFA

Analytic Investors
Steven Thorley, CFA

Brigham Young University
Fundamentals of
Futures and Options
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Biographies
Roger G. Clarke is chairman of Analytic Investors and also serves as presi-
dent of a not-f or-profit investment organization. Previously, he served on
the f aculty of Brigham Young University, where he continues to lecture
as a guest prof essor. Dr. Clarke has written numerous articles and papers,
including three tutorials for CFA Institute. He has served as a member of the
editorial boards of the Journal of Portfolio Management, Journal of Investment
Management, and Financial Analysts Journal. Dr. Clarke received a BA in
physics and an MBA f rom Brigham Young University and an MS in eco-
nomics and a PhD in finance from Stanford University.
Harindra de Silva, CFA, is a portfolio manager at and president of Analytic

Investors. He is responsible for the firm’s strategic direction and the ongo-
ing development of investment processes. Prior to joining Analytic Investors,
Dr. de Silva was a principal at Analysis Group, Inc., where he was respon-
sible for providing economic research services to large institutional investors.
He has written many articles and studies on finance-related topics and is an
associate editor of the Financial Analysts Journal. Dr. de Silva received a BS
in mechanical engineering f rom the University of Manchester Institute of
Science and Technology, an MS in economic forecasting and MBA in finance
from the University of Rochester, and a PhD in finance from the University
of California, Irvine.
Steven Thorley, CFA, is the H. Taylor Peery Professor at the Marriott School
of Management, Brigham Young University. He is also a consultant f or
Analytic Investors. Professor Thorley is a member of the investment commit-
tees of Deseret Mutual Benefit Administrators, Intermountain Healthcare,
and Brigham Young University. He is the author of numerous papers in aca-
demic and prof essional finance journals; he is on the editorial board of the
Financial Analysts Journal and holds several awards for outstanding research
and teaching. Professor Thorley received a BS in mathematics and an MBA
from Brigham Young University and a PhD in financial economics from the
University of Washington.
Contents
Foreword. . ................................................................................. vii
Acknowledgments...................................................................... ix
1. Overview of Derivative Securities and Markets........................... 1
Traditional Derivatives......................................................... 3
Recent Innovations.............................................................. 6
2. Futures Contracts: Pricing Relationships..................................... 9
Pricing a Generic Futures Contract. . ....................................... 12
Equity Index Futures Pricing.. ................................................ 14
Bond Futures Pricing............................................................ 15
Eurodollar Futures Pricing.................................................... 18
Currency Futures Pricing. . ..................................................... 18
Basis and Calendar Spread Relationships................................ 20
3. Futures Contracts: Hedging Relationships.................................. 23
Net Price Created by a Hedge............................................... 23
Synthetic Securities. . ............................................................ 26
The Choice of Contract Maturity........................................... 30
A Generalized Hedging Framework....................................... 34
The Minimum-Variance Hedge Ratio..................................... 35
Theoretical Hedge Ratios..................................................... 37
Controlling Asset Exposure: Asset Allocation. . ........................ 40
4. Option Characteristics and Strategies: Risk and Return................ 45
Option Characteristics. . ........................................................ 45
Option Strategies................................................................ 54
Choosing a Strategy. . ........................................................... 60
Probability Distribution of Returns........................................ 61
Mean–Variance Performance Comparisons............................. 64
5. Option Contracts: Pricing Relationships..................................... 67
Lower-Bound Adjustments for Put and Call Options................ 67
Put–Call Parity for European Options. . ................................... 70
Early Exercise of American Options.. ...................................... 71
Put–Call Parity Bounds for American Options......................... 73
The Binomial Pricing Model.................................................. 75
Two-Period Binomial Pricing Model....................................... 80
Multiperiod Binomial and Black–Scholes Models..................... 85
Black–Scholes Option Price Assumptions................................ 91
Options on Futures.............................................................. 93
6. Option Contracts: Hedging Relationships. . ................................. 97
Sensitivity Measures............................................................ 97
Risk Control Using Sensitivity Measures.. ................................ 107
Alternative Ways to Create Option Effects............................. 111
Implied Volatility Smiles and Term Structure........................... 113
Conclusion. . ........................................................................ 116
Appendix. Interest Rate Concepts. . ............................................... 117
Interest Rate Quotations...................................................... 117
The Term Structure of Interest Rates. . .................................... 120
Measuring Interest Rate Risk................................................ 123
Exercises.................................................................................... 131
Futures Pricing.................................................................... 131
Implied Repo Rates. . ............................................................ 132
Basis and Calendar Spreads.................................................. 133
Hedging Relationships......................................................... 133
Interest Rate Concepts......................................................... 135
Hedge Positions.................................................................. 137
Risk–Return Characteristics of Options................................... 141
Option Pricing. . ................................................................... 147
Option Sensitivities and Hedging.......................................... 155
Synthetic Option Positions. . .................................................. 158
References................................................................................. 161
Glossary . . .................................................................................. 171
This publication qualifies for 5 CE credits under the guide-

lines of the CFA Institute Continuing Education Program.
Foreword
More than two decades have passed since the Research Foundation of
CFA Institute released Roger Clarke’s Options and Futures: A Tutorial. During
this time, the markets for these types of derivatives have grown and matured
into highly f unctional institutions for hedging risk and speculating on price
changes of various assets. Granted, there has been a bump or two along the
way, most notably surrounding the global financial crisis in 2008 and, before
that, the Asian contagion and Long-Term Capital Management crises in the
late 1990s. But overall, the global markets for these instruments have f unc-
tioned quite well.
During this period, the success of options and f utures is evidenced by
the remarkable increase in the trading volume and the number of different
products traded. Although many of these gains have recently moderated,
it is difficult to argue with the success when observing f rom a 20-plus-year
perspective.
Still, derivatives are often vilified in the press and by the uninformed—
despite their valuable contributions in such areas as helping farmers lock in a
price at which they can sell their crops, allowing pension funds to efficiently
add to or decrease their equity exposures to manage portfolio risk, and assist-
ing manufacturers in controlling the impact of currency fluctuations on the
prices of the goods they buy and sell. Essentially, options and futures help to
form a complete market where positions can be taken in practically any attri-
bute of an asset in an efficient manner—a valuable function indeed.
Many changes have occurred in the derivatives markets since Clarke’s
original work was published. Perhaps two of the largest are (1) electronic trad-
ing supplanting open outcry as the platform of choice in a majority of venues
and (2) the massive regulatory reforms that have resulted in over-the-counter
(OTC) derivatives taking on certain characteristics of exchange-traded prod-
ucts. These two impacts, particularly the changing regulatory environment,
are still influencing the markets and will continue to be drivers for change in
the future.
Another notable change involves the globalization of derivatives trading.
The Asia-Pacific region’s share of the global exchange-traded derivatives mar-
ket has exploded over the past decade, and the region now commands a 36%
market share, according to the World Federation of Exchanges. Although
the Americas still hold the lead with a 42% market share, the Asia-Pacific
region’s gains cannot be ignored.
It is within this backdrop of increasing use of derivatives, a wider variety
of products trading, more stringent regulation, and expanding globalization
©2013 The Research Foundation of CFA Institute vii

Fundamentals of Futures and Options
that Clarke and his co-authors, Harindra de Silva and Steven Thorley, have
produced Fundamentals of Futures and Options. The work builds upon the pre-
viously released tutorial to provide a valuable updated overview of options and
futures.
As executive director of the Research Foundation of CFA Institute and a
former options trader, I am honored to present this outstanding book to you.
For those of you who are new to options and futures, this work will provide
valuable insights into these important investment vehicles. For those of you
who have not worked with (or studied) derivatives for a long time, this book
will serve as an important review of what was once known but has grown
rusty. Through the diligence and hard work of the authors, we now have an
updated look at options and futures that can benefit so many of us. We hope
you enjoy it.
Bud Haslett, CFA

Executive Director
Research Foundation of CFA Institute
viii ©2013 The Research Foundation of CFA Institute

Acknowledgments
The authors wish to thank Trevor Flint, Spencer Haf en, and James Toone,
f ormer MBA research assistants to Prof essor Thorley, f or assistance during
this project. We are grateful to the staff at the Research Foundation of CFA
Institute, including Laurence B. Siegel, research director, and Walter (Bud)
Haslett, CFA, executive director, for their encouragement and support.
©2013 The Research Foundation of CFA Institute ix

1. Overview of Derivative Securities and
Markets
Although forward agreements for agricultural commodities have been around

for centuries, the growth in financial derivatives began in the United States
largely in the 1970s with the organization of the Chicago Board Options
Exchange (CBOE). Futures on U.S. Treasury bonds and notes began trading
in the late 1970s, and options on individual stocks and equity indices began
trading in the early 1980s. Since then, not only have derivatives expanded to
other countries, but also, the set of underlying indices or assets has expanded
tremendously. In many cases, the volume of trading in these instruments now
exceeds the volume of trading in physical assets. In addition to the derivatives
traded on commodities and currencies, derivatives are now traded on market
volatility, inflation, weather, real estate, and a wide array of equity, interest
rate, and credit indices. Many of these contracts require complex calculations
f or modeling the expected payoffs. These calculations could not have been
done without the increased data-handling capabilities and computational
power of modern computers. Many bright engineers and mathematicians
migrated to Wall Street firms to work on the sophisticated models for pricing
these complex structures.
In addition to the growth of traditional exchange-traded derivatives,
the design of securities with embedded options has become common.
Furthermore, many fixed-income transactions that generate an income
stream have been dissected and separated into layers of priority in receiving
the cash flows. These are sometimes called structured or tranched securities.
In general, the higher-priority tranches have a higher credit quality than the
lower-priority tranches. The credit crisis that began in 2007 and 2008 hit
these securities particularly hard, and many became worthless.
Swaps are another form of derivatives that have grown substantially since
the original edition of this book. Specifically, swaps are used extensively
by financial institutions and institutional investors to hedge risk in other
assets they hold or to take outright (unhedged) exposures. As with forwards,
f utures, and options, the volume of trading in the swaps market can exceed
the volume of trading in the underlying physical assets. The development of
complex derivatives and their expanded use has been an important trend in
investment and risk management. We treat only relatively simple option and
futures contracts in this book, however, leaving a detailed discussion of more
complex derivatives to others. Table 1.1 shows some of the more popular
financial futures contracts as of 2013.
©2013 The Research Foundation of CFA Institute 1

Table 1.1. Selected Financial Futures Contracts, Notional Values, and Exchanges
Contract Contract Notional Value Exchange
Equity indices
DJIA $10 × index CBT
Mini DJIA $5 × index CBT
S&P 500 Index $250 × index CME
Mini S&P 500 Index $50 × index CME
Mini Russell 1000 $100 × index ICE-US
Mini Russell 2000 $100 × index ICE-US
Interest rates
T-bonds $100,000 CBT
T-notes $100,000 CBT
Five-year T-notes $100,000 CBT
Two-year T-notes $100,000 CBT
13-week T-bill $1,000,000 CME
30-day federal funds $5,000,000 CBT
Eurodollar $1,000,000 CME
Foreign exchange
Japanese yen ¥12,500,000 CME
British pound £62,500 CME
Euro €125,000 CME
Swiss franc SFr125,000 CME
Canadian dollar C$100,000 CME
Australian dollar A$100,000 CME
Notes: DJIA is Dow Jones Industrial Average; CME is Chicago Mercantile Exchange; CBT is
Chicago Board of Trade; and ICE-US is Intercontinental Exchange US.
The growth of derivatives created an incentive f or investors to better

understand the instruments and the impact they have on asset and risk man-
agement. This incentive has manifested itself in several directions.
First, much work has been done by researchers to understand the impact
derivatives have on asset management strategies. Institutional investors
needed to know how these instruments worked and how they could be used
to develop new investment strategies. When the forerunner of this book was
first published, the benefits and risks associated with many derivative strate-
gies were not well understood, nor were the processes that were needed when
2 ©2013 The Research Foundation of CFA Institute

Overview of Derivative Securities and Markets
the strategies were implemented. For example, as the size of transactions has
increased, an understanding of the cash reserves that need to be set aside for
periodic settlement of losses and cross-margining and the management of
counterparty exposure has become increasingly important.
Second, the desire f or transparency has become much more important
than in the past. Specifically, there was not a standard set of rules on how to
measure and report derivative security exposures. Analysts could not always
tell how much risk an institution had taken on, which made assessing the
overall risk profile of the company difficult. Recent rules have brought more
standardization to the reporting process, but the issues remain complex and
not easily understood by many nonprofessionals.
Third, the growth of derivative transactions and the interconnections
between major financial institutions around the world have led to concerns
about the integrity of the global financial system. For example, derivatives
allow additional leverage to be created in the financial system, and in times
of financial turbulence, that leverage can precipitate a liquidity crisis, magnify
market moves, and accelerate defaults. These systemic concerns have prompted
new regulations, new procedures, and new disclosures to increase transpar-
ency. For example, the growth of hedge funds that make heavy use of deriva-
tives has drawn the attention of regulators.
Traditional Derivatives
Option and futures contracts are derivative instruments, which means that
they derive their value not f rom their own intrinsic cash flows or charac-
teristics but f rom some other underlying security or index. The relation-
ships between the underlying security and its associated option and futures
contracts are illustrated in Figure 1.1. Note that options may be written on
f utures contracts, but all option and f utures ultimately derive their value
f rom an underlying security or index (one that is not an option or f utures
contract). The links pictured in Figure 1.1 keep the security and its options
Figure 1.1. Arbitrage Links
Spot–Futures Parity
(cash and carry)
Option Futures
Security
or Index
Put–Call Parity
Put–Call Parity Futures

Option

and f utures coupled together. The arbitrage link between a f utures con-
tract and the underlying security is called spot–f utures parity or cash-and-
carry arbitrage. The arbitrage linking put and call options to each other is
referred to as put–call parity, which, together with spot–futures parity, links
the options to the underlying security. Various arbitrage-based relationships
and option-pricing models are discussed in more detail in the later chapters
of this book.
Futures and option contracts share some common characteristics but also
have important differences. The common features of exchange-traded futures
and options include standardized contract provisions, trading on organized
exchanges, limited maturity, risk management capabilities, and operational
efficiencies. The key conceptual difference between f utures and option con-
tracts is that a futures position represents the obligation to buy (long position)
or sell (short position) the underlying asset in the f uture whereas an option
represents the right, but not the obligation, to buy (call option) or sell (put
option) the underlying asset in the future.
Simply put, a f utures contract is an agreement between a buyer and a
seller to trade an underlying security or index at a f uture date. The most
popular futures contracts are traded on organized exchanges and have stan-
dardized contracts specif ying how much of the security is to be bought or
sold, when the transaction will take place, what features the underlying secu-
rity must have, and how delivery or transfer of the security is to be handled.
To encourage f utures contract buyers and sellers to follow through with the
transaction, a good faith deposit, called initial margin, is required from both
parties when a contract is initiated.
As the price of the underlying security changes from day to day, the price
of the futures contract also changes. The buyer and seller of exchange-traded
futures contracts recognize this daily gain or loss by transferring cash to the
margin account of the party reaping the benefit. This mark-to-market practice
keeps large unrealized losses from accumulating and reduces the probability
of one of the parties defaulting on the obligation.
Option contracts possess some of these same features, but the buyer of an
option contract has limited liability and can lose, at most, the price paid for the
option, sometimes called the option’s premium. But the seller of the option has
unlimited liability, which is similar to the parties to a futures contract. As a result,
the option seller is usually required to post initial margin, as in a futures contract.
The exchange-traded contracts’ standardized f eatures allow f utures
and options to be traded quickly and efficiently on organized exchanges.
Exchanges serve as intermediaries to facilitate trading, transfer daily gains and
losses between parties, and pool resources of exchange members to guarantee
financial stability if a single investor should default. The individual parties to
a given trade may never meet and do not need to deal with each other af ter

the exchange has matched their trade. The exchange’s clearinghouse function
allows buyers or sellers to reverse a position before maturity and thus close out
the obligation without having to find the party that initially took the other
side of the trade. For example, a previous buyer of a f utures contract merely
sells a contract with the same parameters, and the clearinghouse cancels the
buyer’s original obligation. In fact, although the buyer of selected futures con-
tracts can require delivery of the underlying assets on the expiration date, most
positions are canceled prior to expiration, so actual delivery is uncommon. The
highest volume of trading, and thus the most liquidity, usually occurs in the
contracts with the nearest maturity dates. As the expiration date of the near-
term contract approaches, investors who want to maintain a f utures position
simply reverse their position in the nearest-term contract and roll their expo-
sure over to the next nearest-term contract.
In addition to the exchange-traded securities that are the f ocus of this
book, there are other types of derivatives contracts, such as f orwards and
swaps. They have characteristics similar to those of exchange-traded futures
and options but are contracts between two specific parties and are referred to
as over-the-counter (OTC) contracts. Settlement of gains and losses on OTC
contracts are not guaranteed by a central clearing organization, so each side
of the transition has counterparty risk exposure. In periods of financial stress,
there may be heightened concern over the ability of a counterparty to settle
outstanding claims, which introduces an additional element of risk. To reduce
the risk that a counterparty may not be able to settle any losses at the expira-
tion of the OTC contract, counterparties have recently been requiring mark-
ing to market of any losses along the way, similar to the daily mark-to-market
process for exchange-traded derivatives.
The use of options and f utures gives the investor flexibility in managing
the risk of an underlying security or index. Basic business activities, such as
banking, international trading, and providing retirement benefits, may leave an
individual investor or corporation exposed to interest rate, foreign exchange, or
equity market risk. The use of options and futures allows the investor to hedge
or transfer all or some of this risk to others more willing to bear it. Derivative
securities can also be used in a speculative way, although most applications
in this tutorial concern risk control or the risk-hedging aspect of futures and
option trading. We f ocus on contracts f or financial assets, such as stocks,
bonds, and foreign exchange, but structured derivative contracts exist for met-
als, energy, agricultural commodities, and other physical commodities.
Trading in options and futures contracts has some operational advantages,
in addition to risk management, over trading in the underlying securities:
• easy adjustment of market exposure,
• reduced transaction costs,

• same-day settlement of simultaneous trades,

• less disruption of underlying asset management, and
• creation of specialized risk/return patterns.
The use of f utures and option contracts allows broad market exposure to be
adjusted at low transaction costs. In addition, unlike the trades in many underly-
ing securities, derivative securities have same-day settlement. Furthermore, posi-
tions in derivative securities can be initiated without the need to buy or sell the
underlying securities, which produces less disruption to an existing investment
program. Finally, derivative securities can be used to create specialized return
patterns.
The use of futures and option contracts also has some disadvantages:
• the need to understand complex relationships,
• potential tracking error against the underlying security or index,
• requirement of liquidity reserves to post and meet margin requirements,
• daily settlement associated with marking to market, and
• potential short-term tax consequences.
Some investors may lack the understanding and experience to use futures and
options effectively. The specifications within futures and option contracts may
not exactly match the investor’s portfolio, and derivative contracts can become
slightly mispriced with respect to the underlying asset, both of which lead to
tracking error in the investor’s strategy. Derivative securities can require more
attention than other securities do because of the daily mark-to-market aspect
and the need to maintain cash reserves. Finally, futures and options have rela-
tively short lives, and closing out positions often creates special considerations
for taxable investors.
Recent Innovations
The largest and most important derivative category not covered in this book
is the swap market, wherein investors effectively trade one income stream
for another. A swap represents a complex combination of f utures contracts.
Although swaps are beyond the scope of this book, f our other derivative
structures that have been more recently introduced to the marketplace are
briefly reviewed here: volatility, credit, real estate, and weather contracts.
Starting in the mid-1990s, trading derivatives based on equity market
volatility became popular. Volatility derivatives gain or lose value depending
on how the volatility of the equity market changes, not on the level of the
market itself. Prominent derivatives in this category include variance swaps

and f utures or options written on a volatility index, such as CBOE Market

Volatility Index (VIX). Investors have found that volatility derivatives are use-
ful for hedging equity risk because a long volatility position typically exhibits
a strong negative correlation with sizable movements in the equity market.
Specifically, volatility tends to increase when the market drops sharply and
then subside as the market recovers. But the effectiveness of volatility deriva-
tives as a hedge is based on a general tendency because the payoff is driven by
the change in market volatility, not the direction of the market move itself, in
contrast to the simple futures contracts that we will cover later in detail.
Credit def ault swaps (CDS) became some of the most popular—and
then most infamous—financial derivatives traded. Contracts have been con-
structed both on portfolios of separate underlying credits and on individual
corporate names. The buyer of a CDS pays a premium, or fee, to the seller of
the swap. In the case of a credit event, the seller makes a cash payment back
to the buyer. Credit events are typically defined as some form of bankruptcy,
f ailure to pay, restructuring, repudiation, moratorium, obligation def ault,
or obligation acceleration. The basic intent of credit derivatives is to trans-
fer credit risk from lenders to third parties while retaining ownership of the
asset. A CDS may thus be regarded as a form of insurance contract, insuring
the buyer against credit def ault and other negative events, although “true”
insurance involves pooling of risks and a CDS does not.
Property derivatives derive their value from underlying real estate assets.
Property derivatives are usually tied to a real estate property index, not to
a specific property. The most common forms are a total return swap, a for-
ward contract, and a futures contract on an index. The buyer of the derivative
receives a payment from the seller if the property index increases and pays the
seller if the property index decreases during the term of the contract. The two
most popular real estate indices in the United States are Radar Logic’s RPX
and the S&P/Case–Shiller Home Price Index. Property derivatives allow the
investor to gain or reduce exposure to the property market, either as a hedge
against physical assets or as a pure investment position, without having to
transact in the underlying properties themselves.
Weather derivatives can be used to take positions with respect to adverse
or unexpected weather conditions. For example, one of the most com-
mon units of measure in weather derivatives is heating degree days (HDD).
Contracts based on HDD are currently traded f or about 25 cities in the
United States. These contracts can help businesses hedge unexpected energy
costs of heating or cooling buildings on the basis of changes in temperature
measured in specific locations. Other weather contracts are based on the
amount of precipitation (rain or snow) in a particular location. Additional
derivatives are tied to the scale of damage f rom hurricanes or earthquakes.
If damages exceed a certain amount, one party helps cover the cost of the

damages incurred by the other. These derivatives became popular in the mid-
1990s as insurance companies looked for ways to spread the risk of insuring
the damages from catastrophic events. These types of derivatives also provide
an interesting alternative whose returns are uncorrelated with the returns
from typical financial markets. The creation of new derivative contracts that
meet the risk transfer and speculative needs of various investors will undoubt-
edly continue in the 21st century, as will the development of regulatory struc-
tures to ensure well-functioning financial markets.

2. Futures Contracts: Pricing
Relationships
A f utures contract provides an opportunity to commit now to purchase

or sell an underlying asset at a specified price, with delivery and payment
delayed until the settlement date. A futures contract can be either “bought”
or “sold.” The buyer of a futures contract has a long position and commits to
buying the underlying asset or security at the specified price and date. No
money changes hands up front, except for the posting of initial margin. The
seller of a f utures contract has a short position and commits to selling the
underlying asset or security at the specified price and date. The fact that the
futures price is negotiated now but delivery and payment are delayed until
the settlement date creates an opportunity cost f or the seller in receiving
payment. As a result, the negotiated price f or f uture delivery of the asset
differs f rom the current cash price by an amount that reflects the cost of
waiting to get paid.
Strictly speaking, a two-party buy/sell agreement without margin require-
ments or a mark-to-market feature is simply forward contracting, which was
a common practice f or trading agricultural commodities (e.g., wheat) long
before the establishment of formal futures exchanges in the 20th century. The
more formal f utures contract contains many of the same elements as a for-
ward agreement, but gains or losses that accrue as the price of the underlying
asset fluctuates are realized on a day-to-day basis. In other words, the total
accumulated gain or loss is the same for a f utures contract as for a forward
agreement but is realized (cash is transferred) on a daily basis instead of on
the final settlement date. Futures contracts also require the posting of initial
margin or a performance bond with the broker to initiate the trade. In recent
years, some counterparties in f orward agreements have required settlement
of interim gains and losses if they exceed some predetermined amount. In
either case, the purpose of posted margin is to reduce the chance that one
of the parties to the trade builds up substantial losses and then defaults. The
minimum size of the initial margin varies for different futures contracts but
usually amounts to between 2% and 10% of the notional contract value, as
set by the exchange where the contract is traded. Contracts on more volatile
securities or indices generally require higher percentage margins than con-
tracts on less volatile securities or indices and are occasionally adjusted by the
exchanges in response to market conditions.
Another difference between f orward agreements and f utures contracts
is that f utures contracts have standardized provisions specif ying maturity
date and contract size, so they can be traded on organized exchanges. Most

actively traded markets use f utures contracts, although a substantial forward

market for foreign exchange exists through the banking system. In the United
States, the futures markets are regulated by the Commodity Futures Trading
Commission, but individualized forward agreements are not. In this book, we
will generally treat f utures as forward agreements in discussing pricing rela-
tionships and risk management properties. If interest rates are constant and the
term structure is flat, the two will theoretically be priced the same. Although
these interest rate conditions are not strictly met in practice, the difference in
price between a futures contract and a forward agreement is usually small.
Where do f utures come f rom? Ordinarily, we think of securities as being
issued (sold for the first time) by organizations wanting capital. Such organizations
are typically corporations or governments. Futures, however, are created through
the exchanges when one investor commits to purchase a security at a specified
date from an investor who commits to sell. No new underlying security is created
in the process, only a commitment to exchange at the specified future date.
Table 2.1 lays out some of the algebraic notation we will use in referring
to f utures contracts. At Time 0, or “now,” the underlying security and each
of two futures contracts has a current price, subscripted by 0. Remember that
the f utures price is the price investors agree on today for delayed purchase or
sale of the security at a f uture expiration date. Futures contracts are usually
traded with several different expiration dates, although for simplicity, Table 2.1
includes contracts for only two dates—a nearby date, Time 1, and a “deferred”
date, Time 2—as shown by superscripts. When the first of these two dates
arrives, the underlying security price will probably have moved to a new value,
subscripted by 1. The change in the price of the underlying security also leads to
new prices for both futures contracts, also subscripted by 1. When the second
date arrives, the security price will have moved again to yet another new value,
subscripted by 2. Note that after Time 1 has passed, the nearby futures contract
has expired and is no longer traded, so no price is listed for Time 2.
As our first example of the Time 0 prices in Table 2.1, we quote in Table
2.2 the futures prices for the Mini S&P 500 contract for the close of markets
on Tuesday, 15 May 2012. The S&P 500 Index closed that day at 1,330.66.
As shown in Table 2.2, the June f utures contract price is a bit lower, at
Table 2.1. Algebraic Notation for Futures Prices

Price Time 0 (now) Time 1 Time 2
Security price S0 S1 S2
Nearby futures price F01 F11 —
Deferred futures price F02 F12 F22

Futures Contracts: Pricing Relationships
Table 2.2. Futures Prices for Mini S&P 500 Contracts on Tuesday, 15 May 2012
Settlement Open
Price Interest
Index 1,330.66
June settlement 1,328.25 2,870,892
September settlement 1,321.75 32,285
1,328.25, and the September f utures price is lower still, at 1,321.75. As the
reader will see, the arbitrage pricing relationship causes the contract with the
more distant expiration date to have a lower price because the dividend yield
on U.S. stocks is currently greater than the interest opportunity cost of money
(i.e., prevailing short-term U.S. interest rates).
In some prior periods (say, the 1990s), prevailing short-term interest rates
were higher than the dividend yield on stocks, so futures prices were increas-
ingly higher for more distant expiration dates. If short-term interest rates move
higher than dividend yields in future years, then the pattern of futures prices
will shift back to being increasingly higher for more distant expiration dates.
The last column of Table 2.2 gives the open interest, defined as the number
of contracts that have been purchased and are still outstanding. The specifica-
tion for each Mini S&P 500 futures contract is $50 multiplied by the index level
(see Table 1.1), so the notional value of each June contract is $50 × 1,330.66 =
$66,533.00. Although no “price” is paid now for a short or long position in the
futures contract, the initial margin requirement set by the exchange might be
$5,625 per contract. Notice that most of the open interest shown in Table 2.2 is
in the nearby June contract rather than the September contract.
The data in Table 2.2 can be used to illustrate the mark-to-market response
to daily fluctuations in the futures price. Suppose that on Wednesday, 16 May
2012, the June f utures contract drops 6.00 points. The price move generates a
loss of $50 × 6.00 = $300 per contract, which is taken out of the margin account
for the long position (i.e., the prior buyer of this futures contract) and placed in
the margin account f or the short position (i.e., a prior seller of this contract).
Over time, the mark-to-market transferring of cash from one investor’s margin
account to another’s account will be the same as if the cash transfers were all
postponed to the expiration date, as they might be in a simple forward agreement.
Also notice the implicit leverage involved in buying or selling a futures
contract. For a 6-point drop in the June f utures price, the percentage
change is only 6.00/1,330.66 = 0.45%. The margin account of investors with
a short position in the June f utures increases by $300 per contract, a gain
of 300/5,625 = 5.33% on the initial margin deposited and a leverage factor
of about 11.8 to 1 (5.33/0.45). So, futures can be used in a highly leveraged
way or a conservative way, depending on how much the investor commits to

the initial margin account. The leverage factor in this example is 11.8 to 1.0
because the initial margin requirement of $5,625 is 8.45% of the $66,533.00
notional value and 11.8 is the reciprocal of 8.45%. If the investor had posted
a larger initial margin of 20%, or 0.20 × $66,533.00 = $13,306.60, the
leverage factor would be only 5 to 1 because 5 is the reciprocal of 20%. If
the investor chose to put the f ull dollar equivalent of the notional f utures
index, $66,533.00, into the margin account, there would no leverage effect
at all; in other words, the leverage factor would be 1 to 1.
Pricing a Generic Futures Contract

As mentioned in the specific example for the Mini S&P 500 futures contract,
the futures price is related to the price of the underlying security or asset, the
opportunity cost until expiration, and any expected cash distributions by the
underlying asset bef ore expiration. Note that f utures are priced in an open
market, where the orders of many buyers and sellers are matched like any other
financial asset, but the futures contract price is tied to the price of the underly-
ing security or index because of the cash-and-carry arbitrage condition. When
the underlying asset price changes, the price of the futures contract will also
change in order to maintain the link. The cash-and-carry arbitrage argument
for a simple f utures contract (ignoring mark-to-market effects) is as follows:
Suppose an underlying security with a current price S0 is scheduled to pay a
cash flow distribution of CFt at time t. (CFt might be a dividend or bond cou-
pon payment.) Table 2.3 outlines two investment strategies that each result in
holding the security at time t, right after the cash distribution has been paid.
In Strategy I, the investor simply buys the underlying security, ending up with
St + CFt at time t. In Strategy II, the investor establishes a long futures position
and saves the funds that would have been used to purchase the security in an
account earning an annualized interest rate, r. At time t, the investor has accu-
mulated S0 (1+ r )t in the savings account and buys the underlying security for
the agreed futures price of F0, independent of its actual ending value, St.
Table 2.3. Cash-and-Carry Arbitrage

Value at Time 0 Value at Time t
Strategy I: Purchase the security S0 St + CFt
Strategy II:
Invest S 0 dollars at rate r for time t S0 S 0(1 + r)t
Establish a long futures position 0 St – F 0
Total value for Strategy II S0 S 0(1 + r)t + St – F 0

Because both strategies begin with the same dollar investment and both end
up owning the security at time t, the ending values should also be equal. In other
words, the value of Strategy I at time t should equal the value of Strategy II at
time t:
t
St + CFt = S0 (1 + r ) + St − F0 . (2.1)
Solving f or the f utures contract price established at Time 0 gives the
arbitrage-free, or “fair,” futures price as
t
F0 = S0 (1 + r ) − CFt . (2.2)
Thus, the f utures contract price represents the current price of the security
adjusted for the opportunity cost of delayed settlement. The seller of the secu-
rity is compensated f or waiting to receive the money by implicitly earning
interest on the current value of the security, netted against any cash distribu-
tions paid on the underlying security before settlement. The adjustment of the
underlying security price to arrive at the f utures price is sometimes referred
to as the cost of carry. Notably, the current futures price does not represent the
expected price of the underlying security at the expiration date. Whatever
investor expectations are, they will be embodied in the current security price
and affect the current futures price through the arbitrage link.
Alternatively, for a quoted futures price, F0, and any scheduled cash flows,
CFt, one can use this relationship to infer what interest rate the buyer has to
pay to compensate the seller, which is ref erred to as the implied repurchase
rate (or simply, repo rate). In most cases, the market adjusts the futures price
until the repo rate equals a widely available short-term interest rate, such as
the Treasury bill yield rate or London Interbank Offered Rate (LIBOR). If
the implied repo rate is substantially higher or lower than these market rates,
arbitrageurs could create a riskless position to capture the differential return.
Specifically, a riskless return higher than the short-term interest rate could
be earned by selling an overvalued futures contract and buying the security.
Alternatively, f unds could be borrowed at below-market rates by buying an
undervalued futures contract and selling the security.
To illustrate how the arbitrage works if the repo rate implied by the
f utures price is too high, consider the following numerical example. A $100
security is scheduled to pay $2 in one month, with the futures price trading at
a value of $99, which is too low. Specifically, an investor with a short futures
position could buy the security today at $100 and sell it in one month at the
contracted price of $99—regardless of what the market price of the security
ends up being at that time. The one-month percentage return, including the
$2 cash distribution, is (99 + 2)/100 – 1 = 1%, or a simple annualized return of
12%. Thus, market participants would be enticed to sell the f utures contract

and purchase the security until their relative prices adjusted enough to result in
a rate of return more consistent with market interest rates, which are currently
much less than 12%. The reverse will happen (i.e., market participants will buy
futures contracts and short the underlying asset) if the repo rate implied by the
futures price is too low (i.e., the futures price is too high).1
We now modify the generic cash-and-carry arbitrage formula to accommodate
four specific underlying assets: equity index futures, T-bond futures, Eurodollars,
and currency futures. Again, we will disregard any complications from marking to
market, so the futures contract will behave like a forward contract.
Equity Index Futures Pricing

If the underlying security is an equity index that pays periodic dividends, then the
generic formula in Equation 2.2 need only be modified in terms of notation, with
Dt for a dividend at time t replacing the more generic CFt for cash flow at time t:
t
F0 = S0 (1 + r ) − Dt . (2.3)
Thus, when equity dividend yields are greater than short-term interest rates,
as is the case at the writing of this book, the fair futures price will be less than
the underlying index. This situation can be seen more clearly by modif ying
Equation 2.3 to incorporate the annualized dividend yield, d, expressed as a
yield on the initial price:
t
F0 = S0 (1 + r − d ) . (2.4)
Equation 2.4 makes it clear that if d > r, then F0 < S0 for any positive length of
time t. If short-term interest rates revert to levels higher than equity dividend
yields, as they were for most of the latter half of the 20th century, then r > d
and the futures price will again exceed the current index value, F0 > S0.
Consider, as an example, the Mini S&P 500 contract in which the two
closest quarterly expiration dates are June and September, shown in Table 2.2.
Note that this futures contract does not require the actual purchase or sale of
the shares of stock at the expiration date; it “settles in cash.” In other words,
if held to expiration, the contract is settled as a cash payment equivalent to
the difference between the index value at that date, St, and the futures price
established up front, F0. Specifically, the long futures position receives a cash
flow of St – F0 through the settlement process at the exchange. If St – F0 turns
1
In contrast to financial futures, shorting the underlying asset may be difficult for some com-
modities, which can create an asymmetry in the arbitrage condition. Imagine taking a short
position in sheep; to get started, you would have to borrow the sheep! In these instances, the
f utures price is rarely higher than its arbitrage value, but it can sometimes go below its arbi-
trage value because the reverse arbitrage of buying the futures contract and shorting the com-
modity may be difficult to execute.

out to be negative, then the holder of the long position pays the exchange,
which then settles with the holder of a short position.
As of the date of this example, 15 May 2012, the Wall Street Journal
quoted a short-term interest rate as 0.24% per year. On the same date, the
annual dividend yield on S&P 500 stocks was quoted as 2.09%. The nearby
contract in Table 2.2 expires on 15 June 2012, exactly one month f rom the
quote date of 15 May. Given that the current (15 May) level of the S&P
500 is 1,330.66, the fair price of the June f utures contract, according to the
arbitrage-free formula in Equation 2.4, would be
1/12
F0 = 1,330.66(1 + 0.0024 − 0.0209) = 1,328.59,
which is close to the actual quote of 1,328.25. This mispricing is probably not
large enough to take advantage of in terms of an arbitrage trade after transac-
tion costs are taken into account.
Suppose, however, that the futures price were quoted at 1,330.25. Then,
solving f or r in the arbitrage-f ree f ormula of Equation 2.4 would give the
annualized repo rate as
12
 1, 330.25 
  − 1 + 2.09% = 1.72%,
 1, 330.66 
which might signal an exploitable arbitrage opportunity at current interest
rates. Specifically, if the f utures contract price were set at 1,330.25, a large
institutional investor could borrow U.S. dollars for one month at the annual-
ized rate of 0.24% and set up a risk-free return of 1.72%.
Bond Futures Pricing

At its core, the pricing of a bond f utures contract is driven by the same
arbitrage principle as any other financial f utures contract. Specifically, the
arbitrage-f ree f utures price is equal to the current bond price adjusted f or
delayed delivery by using a short-term interest rate minus any interim cash
flows. Several bond market and bond futures contract conventions, however,
complicate a simple demonstration of arbitrage trades. These complications
include flexibility in what constitutes the underlying asset, the quoting con-
ventions of “accrued interest,” and nondecimal pricing.
The first complication to the arbitrage logic for bond futures is that the under-
lying asset that drives the arbitrage may be one of several different bond issues.
For example, the T-note futures contract listed under “Interest rates” in Table 1.1
can be satisfied with delivery of almost any U.S. Treasury security with a matu-
rity from 6.5 to 10.0 years and a variety of coupons. Thus, calculation of the fair
futures price must include a factor that converts the price of any particular bond
to one common standard, generally described as the “10-year 6% coupon bond.”

The second complicating issue is that bond price quotes include an accrued
interest factor that adjusts the actual trading price for the days before the next
semiannual coupon payment. Finally, bond prices are almost always quoted
as a percentage of par value (instead of, say, dollars, euros, or yen), which in
and of itself is not a problem. But for increments in price finer than a whole
percent, bond markets often use 32nds of a percent rather than decimals.
Table 2.4 shows f utures prices f or the T-note contract trading on the
Chicago Mercantile Exchange (CME) on 15 May 2012 for both June (one
month out) and September (four months out) settlements. The June contract
has a price of 133-12, or 133 and 12/32nds of a percent of $1,000. After some
arithmetic, the price works out to be $1,333.75 established today (15 May
2012) for delivery of an allowable T-note one month f rom now. In the sec-
ond example in Table 2.4, the September futures price of 132-11 is 132 and
11/32nds of a percent of $1,000, which translates into $1,323.44 after round-
ing to the nearest cent.
Note that the pattern in Table 2.4 of declining prices for longer settle-
ment contracts is the same as it was f or equity index f utures in Table 2.2.
The pattern is driven by the fact that in 2012, short-term interest rates were
lower than the coupon rates underlying the futures contract prices. If short-
term interest rates were to move to higher levels at some future date, then the
T-note f utures contract prices would increase with longer settlement dates.
Also, actual delivery in settlement of a single contract requires 100 bonds.
U.S. Treasury bonds have par values of $1,000 per bond, so the notional value
of one T-note futures contract is $100,000, as shown in Table 1.1.
Including a factor, f, for conversion to the standard “10-year 6% coupon”
bond price and accrued interest adjustment, AI, renders the generic cost-of-
carry arbitrage formula for futures in Equation 2.2 for bonds as
( S0 + AI ) (1 + r )t (2.5)
F0 = .
f
Although a 10-year 6% coupon Treasury was not in the market on 15 May
2012, there was a newly issued 1.75% coupon bond with a maturity date of 15
May 2022 expiring in exactly 10 years. The price quote for that bond on 15
May was 99 25/32% of par, or $997.81, which constitutes a yield to maturity of
Table 2.4. Futures Prices for T-Note Contracts on

Tuesday, 15 May 2012
Settlement Month Settlement Price Open Interest
June 133-12 1,854,934
September 132-11 20,190

1.77%. An investor with an outstanding short position in the June futures con-
tract could choose to settle that contract by delivering the 1.75% coupon bond
but would have to apply an issue-specific conversion factor. Conceptually, the
conversion factor would be calculated as the price at which the 1.75% coupon
bond would have a 6.00% yield. For example, ignoring the fact that the bond
would be just shy of a full 10-year maturity in June 2012, a simple bond calcula-
tion (exact 10-year maturity and 20 semiannual coupon payments of 0.875% to
yield 3.000%) gives a conversion factor of 0.6839. In fact, the official conversion
factor posted by the CME for this bond as settlement of the June futures con-
tract was slightly higher at 0.6897. The conversion factor for this same 1.75%
bond for the September, rather than June, futures contract was 0.6956.
Because the futures contract allows many different bonds to be delivered
in settlement of the contract, the price is generally driven by the “cheapest-
to-deliver” bond, which may not be the 1.75% coupon bond. Thus, we can-
not directly verif y the cost-of-carry formula, Equation 2.5, using the 1.75%
coupon bond, even given the conversion factor. Specifically, the 1.75% bond
is not likely to be the cheapest-to-deliver bond, so a direct application of
Equation 2.5 would result in an implied repo rate that would have been mate-
rially below prevailing short-term interest rates, perhaps even negative. The
implied repo rate would be biased low because the cheapest-to-deliver bond
(found by a search over all admissible bonds for the lowest value of S0 / f, with
accrued interest ignored) would, by definition, result in a higher r.
However, we can use the conversion f actors for the newly issued 1.75%
coupon bond to determine the relative fairness of the two f utures quotes in
Table 2.4. The spot price, S0, and accrued interest, AI, fall out, and the cost-
of-carry arbitrage between the futures contracts is
f 2 F02 t −t1
= (1 + r ) 2 , (2.6)
f1F01
where F01 and F02 are the current (15 May 2012) f utures prices of, respec-
tively, the near-term (June) and longer-term (September) contracts; f 1 and f 2
are the conversion factors for any specific deliverable bond; and t 2 – t1 is the
time, in years, between contract settlement dates. Given the prices quoted in
Table 2.4 and the conversion factors for the newly issued 1.75% coupon bond,
Equation 2.6 produces
0.6956 (1, 323.44 ) 3/12
= (1 + r ) ,
0.6897 (1, 333.75 )
which implies an annualized repo rate of r = 0.30%, close to the level of short-
term interest rates in May 2012. To be precise, the implied repo rate in this
calculation represents the forward interest rate for the three months from 15

June to 15 September, rather than the one-month spot rate on 15 May. See the
appendix for a discussion of forward rates and spot rates.
Eurodollar Futures Pricing

Eurodollar futures, perhaps the most widely traded contracts in the world, are
listed as the last item under “Interest rates” in Table 1.1. Eurodollar contracts
are cash settled, but the underlying asset is the three-month interest rate on
U.S. dollar deposits established in Europe. The contracts have a notional
value of $1,000,000 and, like the other futures contracts we have discussed,
quarterly expiration dates.
For example, Table 2.5 provides quotes f or June and September
Eurodollar futures on 15 May 2012.
Eurodollar futures are quoted as an index formed by subtracting the per-
centage forward rate for the three-month LIBOR f rom 100. Arbitrage-f ree
pricing may not be as apparent in Eurodollar futures as in the other contracts
we have studied, but the arbitrage process does keep these settlement prices
consistent with implied forward rates.
Table 2.5. Futures Prices for Eurodollars on Tuesday,

15 May 2012
Settlement Month Settlement Price Open Interest
June 99.495 960,070
September 99.375 934,289
Currency Futures Pricing

The fair pricing of a f utures contract on foreign exchange follows the same
basic arbitrage logic of the other f utures contracts. Specifically, the f utures
price is equal to the spot currency exchange rate adjusted for the relative cost
of funds in each of the two currencies:
t
 1 + rd 
F0 = S0  , (2.7)
 1 + rf 
 
where
rd = short-term domestic interest rate
rf = short-term foreign interest rate
S0 = current exchange rate (quoted as home currency per foreign currency)
Equation 2.7 incorporates an opportunity cost at the domestic interest rate as well
as the opportunity cost at the foreign interest rate. Because it involves two separate
interest rates, this arbitrage relationship is often called covered interest arbitrage.

To understand covered interest arbitrage, consider the two following invest-

ments. In one strategy, the investor saves $1.00 (the domestic currency in this
example) at an annual rate of rd for t years. As an alternative strategy, the inves-
tor could convert $1.00 to the foreign currency (i.e., divide by the exchange rate,
S0), receive interest at the foreign rate, rf , for t years, and contract to convert the
proceeds back into the domestic currency at the forward exchange rate, F0.
Because both strategies invest the same beginning amount and result in
the accumulation of a known amount at expiration, both strategies should
result in the same value at time t. In other words,
$1.00
$1.00 (1 + rd )t = (1 + r f )t F0 .
S0
Solving for the appropriate forward exchange rate, F0, gives the expression for
the covered interest arbitrage in Equation 2.7.
For a numerical example, consider the currency f utures contract
between U.S. and Australian dollars, listed as the last item in Table 1.1.
The spot exchange rate in USD/AUD terms is 0.9936, so that an Australian
dollar is worth 99.36 U.S. cents. Table 2.6 shows the f utures contract
prices f or June and September settlement of USD/AUD exchange rates.
The open interest is substantially higher f or the near-term contract, as is
typical for most futures. The futures price is lower for the deferred expira-
tion in Table 2.6 because the interest rate in Australian dollars is higher
than the U.S. dollar interest rate. For example, three-month Australian
Treasury bills were priced to yield an annualized 3.20% on 15 May; corre-
sponding three-month U.S. Treasury bills were priced to yield an annual-
ized rate of only 0.07%.
Table 2.6. Futures Prices for Australian Exchange Rates

on Tuesday, 15 May 2012
Settlement Price Open Interest
Spot price 0.9936
June settlement 0.9915 144,207
September settlement 0.9834 650
To check on the fairness of the futures prices in Table 2.6, we can apply
the covered interest arbitrage formula using the current exchange rate and the
respective interest rates of the two currencies. For example, the arbitrage-free
futures price for June settlement is
1/12
1 + 0.0007 
F0 = 0.9936   = 0.9911,
1 + 0.0320 

which is quite close to the June futures quote of 0.9915 in Table 2.6. Similarly,
the arbitrage-free futures price for September settlement,
4 /12
1 + 0.0007 
F0 = 0.9936   = 0.9835,
1 + 0.0320 
is also quite close to the 0.9834 quote in Table 2.6.

As with contracts on other types of financial assets, the f air f utures
price does not represent the price that investors f orecast f or the underly-
ing asset in the future. Those expectations are captured in the current spot
price and influence the f utures price only indirectly through the arbitrage
relationship. The futures price is simply the price for delayed settlement of
the transaction.
Basis and Calendar Spread Relationships

The difference between the spot price of the underlying asset and the futures
price, S0 − F0 , is often referred to as the contract’s basis. Using the cash-and-
carry logic on an underlying security with expected cash flow CFt , we find
the arbitrage-free basis should be
t
Basis = S0 − F0 = S0 1 − (1 + r)  + CFt . (2.8)
 
Because the expected cash flows from the underlying asset of ten exceed the
opportunity cost of funds, the basis is often positive. For an underlying asset
with zero expected cash flow, however, the basis defined as S0 − F0 would be
negative. In that case, for convenience, analysts commonly reverse the defini-
tion of the basis to F0 − S0 so that it is a positive number. Specifically, for an
underlying asset with zero cash flows, the fair basis is often quoted as
t
Basis = F0 − S0 = S0 (1 + r) − 1. (2.9)
 
For either definition of the basis, the interest opportunity cost of funds, as
well as any expected cash flows, declines as the f utures expiration date nears.
This decline forces the basis toward zero at contract expiration, a process called
convergence. Specifically, with arbitrage-free pricing, the futures and spot prices
will converge so that the futures price for same-day delivery equals the spot price.
The difference between a near-term (time t1) and a longer-term (time
t 2) futures price on the same underlying asset,  F01 − F02, is called the calen-
dar spread. As with the basis, the calendar spread will be positive if the
cash flows from the underlying asset exceed the opportunity costs of funds:

t t
Spread = F01 − F02 = S0 (1 + r) 1 − (1 + r) 2  + CF1 − CF2 . (2.10)
 
But for an underlying asset with zero expected cash flow, the definition of spread
is sometimes reversed so that the spread can be quoted as a positive number:
t t
Spread = F02 − F01 = S0 (1 + r) 2 − (1 + r) 1 . (2.11)
 
Figure 2.1 illustrates how, f or an underlying asset with a zero

expected cash f low, the basis declines over time. The basis of the near-
term contract declines to zero at time t1, the near-term expiration date,
whereas the calendar spread between the two contracts remains relatively
constant. The basis of the longer-term contract, which is the sum of the
near-term contract basis and the calendar spread, also declines over time
but does not converge to zero until time t 2 , the expiration date of the
longer-term contract.
For numerical examples of basis and calendar spread, consider the June and
September Mini S&P 500 f utures contracts in Table 2.2. Because the S&P
500 Index provides a significant expected cash flow in the form of dividends,
we measure the basis of the near-term contract as the spot minus futures price:
Basis = S0 − F01 = 1, 330.66 − 1, 328.25 = 2.41,
a value that will slowly converge toward zero as the June settlement date
approaches. As discussed in the section on the Mini S&P 500 contracts,
the relative values of the spot and futures prices are indicative of one-month
interest rates available on 15 May 2012 and the expected dividend yield. The
Figure 2.1. Futures Contract Basis and Calendar Spread
Value
F2 – S
F1 – S
Calendar
Spread
Basis
0
t1 t2
Time

calendar spread between the September and June Mini S&P 500 contracts in
Table 2.2 is
Spread = F02 − F01 = 1, 328.25 − 1, 321.75 = 6.50,
which should remain fairly constant for the life of the near-term contract. The
relative prices of the September and June contracts, together with the S&P
500 dividend yield, are, in fact, indicative of the three-month forward interest
rate starting on 15 June that investors can lock into on 15 May.
Whereas a contract’s basis is defined as a simple difference in prices, a
related concept is the ratio of the futures price to the spot price, F0 / S0 , which
remains fairly constant, even with large movements in the price of the under-
lying asset. Specifically, if the underlying asset has zero expected cash flow,
the arbitrage-free ratio of the futures price to the spot price is
F0 t
= (1 + r ) , (2.12)
S0
which converges toward 1.0 as the contract nears expiration.
As we discuss in the next chapter, the insensitivity of this ratio to sudden
changes in the spot price makes the futures contract a good hedging instru-
ment for investors with an exposure to the underlying asset. Although options
contracts can also be used to hedge risk, the reader will see in later chapters
that the ratio of an option price to the price of the underlying asset can change
dramatically with the price of the underlying asset. Similarly, whereas the
calendar spread is typically defined as a simple difference, the ratio of the
longer-term to near-term futures contract prices, F02 / F01 , remains fairly con-
stant over time, despite potentially large movements in the price of the under-
lying asset. The stability of this ratio facilitates rolling a hedge over from one
futures contract to another as the near-term contract expires.

3. Futures Contracts: Hedging
Relationships
Futures can be used to provide leveraged exposure to an asset or asset class
or to control, and potentially eliminate, the risk of the underlying asset. This
chapter f ocuses on the use of f utures to offset risk by “hedging” an invest-
ment position. The first section describes a general f ramework to illustrate
the essential characteristics of hedging. Subsequent sections discuss specific
applications of the general framework.
Net Price Created by a Hedge

Suppose an investor currently (Time 0) holds an asset priced at S 0. To hedge
the risk of price changes for that asset, the investor sells a f utures contract
at a price of F 0. At time t, the security is worth St, the futures contract has a
price of Ft, and the basis is the difference between the two prices, as shown in
Table 3.1.
Table 3.1 Futures Basis

Security Futures Basis
Now (time 0) S0 F0 S0 – F 0
Later (time t) St Ft S t – Ft
We next discuss various ways the value of the total hedged position (secu-
rity and short futures contract) at time t can be described using these variables.
One way to express the final value of the hedged position, Pt, is the
price of the underlying security at time t, plus the gain or loss on the short
futures contract:
Pt = St + ( F0 − Ft )
(3.1)
= Ending security price + Short futures gain.
A rearrangement of the variables gives the value of the hedged position at
time t in two other, equivalent forms. First, Equation 3.2 shows that the value
of the hedged position is the futures price at Time 0 plus the basis at time t:
Pt = F0 + ( St − Ft )
(3.2)
= Initial futures price + Ending basis.
Second, Equation 3.3 shows that the value of the hedged position can be
thought of as the security price at Time 0 plus the change in the basis between
Time 0 and time t:

Pt = S0 + ( St − Ft ) − ( S0 − F0 ) 
(3.3)
= Initial security price + Change in basis.
All three forms are equivalent ways of expressing the value an investor
creates by hedging an underlying security using a futures contract.
Perhaps the most intuitive interpretation of the three expressions rela-
tive to the notion of hedging is the second, Equation 3.2, in which the value
of the hedged position is equal to the current price of the f utures contract
plus the basis at time t. Specifically, an investor who sells a futures contract
agrees to sell the underlying asset at the now-current futures price. On the
one hand, if the time horizon for the hedge is equal to the expiration date
of the futures contract, then the ending basis at that date is generally zero.
In this case, the value of the hedged position is equal to the current futures
price no matter what subsequently happens to the price of the underlying
security. In other words, the investor has created a riskless position by hold-
ing the underlying security and selling a f utures contract. On the other
hand, if the time to expiration of the f utures contract exceeds the hedge
horizon, the net carrying cost for the holding period is different from what
is implied in the current futures price. Consequently, the value differs from
the price of the current futures contract by the remaining portion of the net
carrying cost reflected in the basis at time t. Thus, a hedged position reduces
the fundamental price risk in the underlying security to the price risk in the
basis, as shown in Equation 3.2. Based on the intuition of this expression,
using a f utures contract to hedge is sometimes referred to as speculation in
the basis.
Alternatively, the investor can think of the value of the hedged position
as equal to the current price of the security plus the change in the basis
between Time 0 and time t, as shown in Equation 3.3. The convergence of
the futures contract price to the security price over time makes the hedged
value differ from the current cash price of the security by the convergence
in the basis.
Perhaps the most common hedging scenario is when an investor sells
a f utures contract to hedge the price risk of an underlying asset. Because
the asset is already in the investor’s portf olio, or “inventory,” this hedge
is sometimes ref erred to as an inventory hedge. An alternative scenario,
which yields exactly the same interpretation, is referred to as an anticipa-
tory hedge. In an anticipatory hedge, an investor purchases (i.e., establishes
a long f utures position in) a f utures contract now, in anticipation of pur-
chasing the underlying security at some future time t. At time t, the inves-
tor purchases the security and sells the f utures contract to close out the
long futures position. The net price, Pt, the investor will have paid for the

Futures Contracts: Hedging Relationships
security position will be equal to the security price minus the gain or loss
on the long futures position.
The expression f or this anticipatory hedge is similar to the inventory
hedge developed previously, in which the net price equals the ending security
price minus the futures gain/loss:
Pt = St − ( Ft − F0 ) . (3.4)
Rewriting the net price in the two additional forms shows that the investor
with an anticipatory hedge can think of the net price paid for the security as
being equal to the current futures price plus the ending basis,
Pt = F0 + ( St − Ft ) , (3.5)
or, equivalently, as equal to the current security price plus the change in basis,
Pt = S0 + ( St − Ft ) − ( S0 − F0 )  . (3.6)
An investor who takes a position in the futures market now in anticipa-
tion of converting that position into the underlying security at time t essen-
tially creates the same price as one who buys the security now and hedges
the price risk until time t. The two strategies are mirror images because
both make a commitment to buy or sell the underlying security at time t.
The price the market is offering the investor for delayed settlement of the
transaction is the same for both strategies and is represented by the current
futures price.
As a specific example of an anticipatory hedge, suppose an investor
expects to receive funds in two months that will then be deposited to earn
the Eurodollar rate. Fearing that interest rates may fall between now and
then, the investor decides to hedge by purchasing Eurodollar futures now.
Suppose the market currently offers a f utures price of 98.5, which repre-
sents an annualized interest rate of 100 – 98.5 = 1.5%. The current spot
price for Eurodollar deposits is 98.2, which represents an interest rate of
100 – 98.2 = 1.8%. In two months, suppose Eurodollar rates have f allen
to 1.1% and the futures price has thus risen 0.4 points to 98.9, as shown in
Table 3.2.
Table 3.2 Futures Basis Example

Security Futures Basis
Now 98.2 98.5 –0.3
Two months later 98.9 98.9 0.0
Net change 0.7 0.4 0.3

The gain of 0.4 points on the f utures contract serves to increase the net
interest rate the investor will receive over and above the then-current rate of
1.1%. Using Equations 3.4, 3.5, and 3.6 for the net price at time t gives
Pt = Endingsecurity price − Futuresgain = 98.9 − 0.4 = 98.5
Pt = Beginning futures price + Ending basis = 98.5 − 0.0 = 98.5
Pt = Beginningsecurity price+Change in basis = 98.2 + 0.3 = 98.5.
The net price of 98.5 allows the investor to enjoy an interest rate of 100 –
98.5 = 1.5%, even though rates had fallen to 1.1% when the investment was
made. Of course, interest rates might have increased over the two-month
period, in which case the anticipatory hedge would have incurred a loss
that offsets the potentially higher interest rate. Note that the expiration
date of the f utures contract in this example is also the date at which the
investor plans to invest, so the basis has completely converged to zero. If
the expiration date of the f utures contract were longer than two months,
the basis probably would not have completely converged to zero and the
hedge would still contain some basis risk.
In summary, the price the hedger receives when constructing an
inventory hedge for an existing security position, or when constructing an
anticipatory hedge for an intended position, is equal to the current futures
price plus whatever the basis is at the termination of the hedge. By using
interest rate hedging, the investor locks in the interest rate implied by the
futures contract rather than the current spot interest rate. The promise of
delayed settlement is offered by the market at the futures price, which will
not be equal to the current spot price unless the net cost of carry happens
to be zero.
Synthetic Securities
Another way to think about the use of f utures contracts is that cash-and-
carry arbitrage ensures that the f utures contract plus a cash reserve behaves
like the underlying security:
Futures + Cash ↔ Security
Specifically, an investor may wish to create the same risk–return profile as
the underlying security but use a futures contract because the transaction can
often be done more quickly and at less cost than buying or selling the under-
lying security. Such a process can be thought of as creating a synthetic security
in place of the actual security.
As shown in Table 2.2, the S&P 500 Index was at 1,330.66 on Tuesday,
15 May 2012. Three weeks later, on Tuesday, 5 June, the index had fallen to
1,285.54, for a loss of 1,285.54/1,330.66 – 1 = –3.39%. Dividends received on

the S&P 500 stocks over this three-week period amounted to about $1.60,
so the total return to an investor in the S&P 500 portfolio was (1,285.54 +
1.60)/1,330.66 – 1 = –3.27%.
The quotes in Table 3.3 can be used to illustrate the parallel perf or-
mance of the underlying security and the synthetic security created by
using the f utures market plus a cash reserve. The investor puts the same
dollar amount as the security purchase, $1,330.66, into a cash reserve pay-
ing interest of 1 bp (basis point) per week and purchases a futures contract.
Three weeks later, the synthetic security will have a value of 1,331.06 +
(1,285.00 – 1,328.25) = 1,287.81 and a return of 1,287.81/1,330.66 – 1
= –3.22%. The 3.22% return is composed of a 0.03% return on the cash
reserve for three weeks and a –3.25% price change from the equity futures
contract relative to the underlying index. The arbitrage between the futures
contract and the underlying index keeps the futures price in a relationship
so that the returns to the underlying and synthetic security will be similar.
Small differences can sometimes occur, as in this case, because of tracking
error between the index and the futures contract.
Table 3.3 Synthetic Equity Using Futures Contracts

Price Three
Price Now Weeks Later Percentage
(15 May) (5 June) Change
Cash reserve $1,330.66 $1,331.06 0.03
Equity futures 1,328.25 1,285.00 –3.25
Futures + Cash 1,330.66 1,287.81 –3.22
The basic arbitrage relationship can also be written to express the creation
of “synthetic cash” as well as a synthetic security. In fact, creating a synthetic
cash position is nothing more than creating an inventory hedge:
Security – Futures ↔ Cash
The cash-and-carry arbitrage relationship keeps the f utures contract priced
so that an offsetting position relative to the underlying security results in a
return consistent with a riskless rate. In essence, creating a hedged position
eliminates the primary risk in the underlying security by shifting it to others
willing to bear the risk. Of course, the risk could be eliminated directly by
simply selling the underlying security position, but this step might interfere
with the nature of the investor’s business, disrupt a continuing investment
program, or incur unwanted transaction costs or taxes. Thus, the futures mar-
ket can provide an alternate way to temporarily offset or eliminate much of
the risk in the underlying security position.

Table 3.4 shows the effect of hedging the risk of an equity portfolio that
tracks the S&P 500. As mentioned previously, over the three weeks following
15 May 2012, the S&P 500 fell by 3.39% and the June (near-term) f utures
contract price fell by 3.25%. If the portfolio had been hedged by shorting the
f utures contract, the net value would be 1,285.54 – (1,285.00 – 1,328.25) =
1,285.54 + 43.25 = 1,328.79, or a return of 1,28.79/1,330.66 – 1 = –0.14%
before dividends. If only half of the portfolio had been hedged, the net value
would be 1,285.54 + 43.25/2 = 1,307.17, for a return of 1,307.17/1,330.66 – 1
= –1.77%, compared with –3.39% for the S&P 500. Using the futures market
allows an investor to temporarily eliminate some or all of the price risk in the
equity portfolio, equivalent to altering the beta. A partial hedge would reduce
the beta below 1.00, and a complete hedge would reduce the beta to zero.
Table 3.4 Synthetic Cash Using Futures Contracts

Price Three
Price Now Weeks Later Percentage
(15 May) (5 June) Change
Equity security $1,330.66 $1,285.54 –3.39
Equity futures 1,328.25 1,285.00 –3.25
Security – Futures 1,330.66 1,328.79 –0.14
A different way of looking at the creation of synthetic cash is to calculate

the repo rate implied in the pricing of the futures contract. From Chapter 2,
we know that the arbitrage-free price of an equity futures contract is given by
Equation 2.3—namely,
t
F0 = S0 (1 + r ) − Dt , (3.7)
where t is the time to maturity of the futures contract measured in years (e.g., t =
1/12 for one month) and Dt denotes the dividends paid on the underlying index
until the expiration date. Solving for the implied repo rate in this formula gives
1/ t
 F + Dt 
r = 0  − 1. (3.8)
 S0 
Thus, the implied repo rate of the S&P 500 f utures contract f or the June
expiration is
12
1328.25 + 1.60 
r =  − 1= − 0.73%.
 1330.66 
Although interest rates were at historically low values in 2012, they were
not negative, indicating that the f utures contract is a bit underpriced. In

theory, an investor could have captured an arbitrage profit by shorting the

stocks in the index and buying the underpriced futures contract, although the
costs of shorting together with transaction costs on both the spot index and
futures contract might have been larger than the potential arbitrage profit. If
an arbitrage is too costly to implement, the futures price may deviate slightly
from its fair value.
The impact of partial or complete hedging can also be seen by examin-
ing the effect on a portfolio’s return profile and return probability distribution.
Figure 3.1 illustrates the return on the hedged portfolio relative to the return on
the underlying security. A partial hedge position reduces the slope of the return
line, so the hedged portfolio does not perform as well as the underlying security
when returns are high but also does not perform as poorly when returns are low.
The greater the portion of the portfolio that is hedged, the lower the slope of
the line. A full hedge produces a flat line, indicating that the hedged portfolio
will generate a fixed return no matter what the underlying asset does. This fixed
return should be equal to the riskless rate if the futures contract is fairly priced.
Figure 3.2 shows how the addition of a futures hedge changes the prob-
ability distribution of returns. If the return distribution for the underlying secu-
rity is symmetrical, with a wide dispersion, hedging the portfolio with futures
gradually draws both tails of the distribution in toward the middle and the
mean return moves toward the riskless rate. A f ull f utures hedge draws both
Figure 3.1. Return Profiles for Hedged Portfolios
Portfolio Return (%)

30
20
10
–10
–20
–30
–30 –15 0 15 30
Return on Underlying Security (%)
Underlying Security 50% Hedged 100% Hedged

Figure 3.2. Return Distribution for Hedged Portfolios
Probability Index
100% Hedged
50% Hedged
Underlying Security
–60 –40 –20 0 20 40 60 80

Return (%)
tails in and puts all of the probability mass at the riskless rate. As the reader
will see in Chapter 4, options generally affect one tail more dramatically than
the other, so the distribution of a portfolio hedged with options becomes quite
skewed, in contrast to the more symmetrical impact of hedging with futures.
The Choice of Contract Maturity

An additional issue to consider is what maturity to use for the futures contract
in constructing the hedge position. If the hedging horizon extends beyond
the expiration of the nearby f utures contract, the hedger using the nearby
contract must switch over to the deferred f utures contract at some point to
maintain the hedge. Thus, the investor has a choice of initiating the hedge
by using the nearby contract and then rolling forward at some point into the
longer-term contract, which is called a stack hedge, or using the longer-term
contract right from the start, which is called a strip hedge.
Rolling the hedge f orward requires that an investor sell a nearby con-
tract with one maturity and buy a def erred contract at some date prior to
the expiration of the nearby contract. Figure 3.3 illustrates the time f rame
for the construction of the stack hedge. In Figure 3.3, t is the rollover date,
t 1 is the nearby contract expiration date, T is the hedge horizon, and t 2 is
the longer-term contract expiration date. Note that an investor who initi-
ates a stack hedge with the nearby contract is exposed to the price risk of
rolling the nearby contract over into the deferred contract on rollover date t.
Although the def erred contract may have the disadvantage of less liquidity
than the nearby contract, a strip hedge that uses only the deferred contract is

Figure 3.3. Hedging Time Frame
Hedge Initiation Nearby Futures Deferred Futures

(Time 0) Expiration (time t1) Expiration (time t2)
Rollover Risk at Basis Risk at Hedge

Rollover (time t) Termination (time T)
not exposed to this rollover risk. Both the stack and strip hedge are exposed,
however, to the eventual basis risk associated with termination of the hedge
prior to the longer-term futures contract expiration date, t 2.
Figure 3.4 illustrates the difference between the contract positions needed
f or the stack and f or the strip. A hedge created using the def erred contract
initially places all the positions into that contract. That position is maintained
throughout the course of the hedge, so no further changes need to be made. A
stack hedge created using the nearby contract first establishes positions in the
nearby contract and then rolls them forward into the deferred contract before
the nearby contract expires. At Time 0, the calendar spread that will exist
between the two contracts on the date of the forward roll, t, is uncertain, so
the net price that the investor receives with a stack hedge will incorporate that
risk, in addition to the basis risk, at time T when the hedge is terminated.
To f urther examine the relative risks of each hedge structure, consider
the net price received at the termination of the hedge under the strip strategy,
which uses only the def erred contract. The net price f or the hedger is the
ending spot price plus the gain in the deferred contract during the life of the
hedge or, equivalently, the current price of the longer-term contract plus its
ending spot–futures basis:
( ) (
PT (Strip) = ST + F02 − FT2 = F02 + ST − FT2 . ) (3.9)
The second formulation in Equation 3.9 shows that the risk of the strip hedge
is caused by the uncertainty of the longer-term contract’s basis at time T, the
termination of the hedge. If the hedge termination is close enough to the
longer-term contract expiration date, this basis risk will be small and will
theoretically, under arbitrage-f ree pricing, converge to zero on the contract
expiration date.
Now, consider the stack hedge that first uses the nearby contract and is
then rolled into the deferred contract at time t. In the stack hedge, the net
price is a function of the gain or loss on both futures contracts. An equivalent
f ormulation f or the net price of the stack hedge is the current price of the

Figure 3.4. Stack vs. Strip Contract Positions
A. Strip Hedge
B. Stack Hedge
Now (time 0) Rollover (time t) Horizon (time T)
Nearby Contract Deferred Contract
nearby contract plus the calendar spread on the date of the roll plus the end-
ing basis of the longer-term contract:
( ) ( ) ( ) (
PT (Stack) = ST + F01 − Ft1 + Ft2 − FT2 = F01 − Ft1 − Ft2 + ST − FT2 . ) (3.10)
The second formulation in Equation 3.10 shows that there are two sources
of uncertainty for the net price of the stack hedge: the risk of the contract
roll (or calendar spread) at time t and the basis risk of the longer-term
contract at time T, the termination of the hedge. Combining Equations
3.9 and 3.10 shows that the difference between the net price of the stack
hedge and the net price of the strip hedge depends on the calendar spread
between the two contracts at the time of the f orward roll relative to the
spread now:
( ) (
PT ( Strip ) − PT ( Stack ) = F01 − F02 − Ft1 − Ft2 . ) (3.11)
Thus, the stack will result in a lower net price to the hedger if the calendar
spread is wider on the date of the roll than at the initiation of the hedge. The

strip gives the investor the chance to roll the hedge into the longer-maturity
contract at a wider spread, but it also entails the risk that the spread may be
narrower. Because calendar spreads are, in part, a function of interest rates,
using the stack exposes the hedge to interest rate risk at time t.
As a numerical illustration of the net prices f or a stack versus a strip
hedge, consider the S&P 500 spot and mini futures prices listed in Table 3.5.
Table 3.5 Spot and S&P 500 Futures Prices on Three Dates
Time 0 Time t Time T
(15 May) (5 June) (26 June)
S&P 500 spot price, S $1,330.66 $1,285.54 $1,319.99
June contract, F 1 1,328.25 1,285.00 —
September contract, F 2 1,321.75 1,278.50 1,315.50
An investor wants to hedge the risk of an S&P 500 portfolio for the six
weeks from 15 May (Time 0) to 26 June (time T ). The investor can use
the longer-term September contract for this hedge or use the nearby June
contract with a rollover to the longer-term contract sometime prior to the
15 June expiration date. The net price of the strip hedge using Equation
3.9 is
( )
PT (Strip) = ST + F02 − FT2 = 1,319.99 + 6.25 = 1,326.24.
Alternatively, suppose the investor chooses the stack hedge and rolls the
hedge into the September contract on 5 June (time t). The net price using the
stack hedge is
( ) ( )
PT (Stack) = ST + F01 − Ft1 + Ft2 − FT2 = 1,319.99 + 43.25 − 37.00 = 1,326.24.
Although no difference resulted between the two hedging strategies in this

numerical example, the potential difference can be described as the change
in the calendar spread between the initiation of the hedge at Time 0 and the
forward roll at time t:
(F01 − F02 ) − (Ft1 − Ft2 ) = 6.50 − 6.50 = 0.00.

In other words, the net prices of the stack and strip hedges are equal in
this example because the calendar spread did not change between the date
the hedge was initiated and the date of the rollover. But changes in calen-
dar spread are possible if unanticipated changes in interest rates or dividend
yields occur or if one or the other futures contract deviates substantially from
arbitrage-free pricing.

A Generalized Hedging Framework

The previous section presented a simple f ramework to illustrate the basics
of using a generic f utures contract to hedge a position in an underlying
security. In this simple f ramework, we assumed that a single contract was
the appropriate position to take f or the purpose of hedging. But a single
exchange-traded contract will generally not match the exact dollar amount
of underlying exposure the investor desires. In addition, the available futures
contracts (e.g., S&P 500 f utures) may not be perf ectly correlated with the
investor’s exposure (e.g., a large-capitalization domestic equity portf olio),
necessitating what is commonly called a cross-hedge. With a cross-hedge, a
dollar position in the futures contract that is equal to the dollar size of the
investor’s asset exposure may not be the optimal hedge. This section dis-
cusses hedging in a framework that accommodates these more involved situ-
ations and then applies that general framework to a variety of specific futures
contracts and underlying securities.
To set up the general framework, we start with an investor who wants to
hedge the value of some asset or security over the short term with a futures
position. Specifically, the hedge is composed of a security priced at S plus h
f utures contracts valued at F. In this context, h is called the hedge ratio and
will generally be a negative number to represent a short futures position. The
change in the hedged value over time as a function of changes in the security
price and the futures price is
∆V = ∆S + h ∆F . (3.12)
Solving for the hedge ratio gives
∆V − ∆S
h= . (3.13)
∆F
The special case of the hedge ratio that completely eliminates the short-
term price risk, so that ∆V = 0, is thus
−∆S
h= . (3.14)
∆F
The short-term hedge in Equation 3.14 might need to be modified to
allow for convergence in the spot–f utures basis over a longer time horizon,
and it assumes that the investor wants the most complete hedge possible.
Nevertheless, the result is intuitively helpful. For example, suppose S is some
well-diversified equity portfolio and F is the S&P 500 futures contract. If the
equity portfolio was, in fact, the S&P 500 Index portfolio, then the arbitrage-
free pricing conditions outlined in Chapter 2 would dictate that the change in
the futures price be approximately equal to the change in the spot price, ∆F
= ∆S, and the short-term hedge ratio would be –1.00. But in general, even a
well-diversified but actively managed large-cap U.S. equity portfolio will not

track the S&P 500 exactly. For example, suppose the beta of the managed
portfolio with respect to the S&P 500 is 0.95 with an additional active risk of
3.0% per year. In that scenario,
∆S = 0.95(∆F )
and the hedge ratio is
−∆S
h= = − 0.95.
∆F
In this example, an investor would sell f utures contracts worth 95% of the
value of the equity portf olio. The hedge would eliminate the short-term
market risk of the portfolio, although not the remaining active risk of 3.0%.
Alternatively, the investor might want to hedge only a portion of the market
risk. For example, the investor might decide to implement a hedge targeted at
60% rather than 100% of the market risk, ∆V = 0.6(∆S). In this scenario, the
hedge ratio would be
∆V − ∆S
h= = (0.60 − 1.00)0.95 = −0.38.
∆F
That is, the investor would sell futures contracts worth only 38% of the value
of the equity portfolio.
The first key point is that most hedges are, in fact, cross-hedges because
the f utures contract does not perfectly replicate the price movement of the
underlying security. A hedge can still be created, but the link between price
movements in the futures contract and the underlying security position will
not be exact, leaving residual risk, or noise, in the relationship. The second
key point is that hedges that completely eliminate market risk are at one end
of the hedging spectrum, with completely unhedged positions at the other
end and a variety of partial hedges in between.
The Minimum-Variance Hedge Ratio

The hedge ratio that minimizes the variance of the net exposure is some-
times referred to as the minimum-variance hedge ratio. The minimum-variance
hedge ratio can be based on the conceptual arbitrage relationship or deter-
mined empirically using regression analysis on historical data. Regression
analysis usually provides a reasonable value for the minimum-variance hedge
ratio. But depending on the length of the measurement period, the number
of periods used, and the assumed stability of the pricing process over the his-
torical period, that estimate can differ from the ratio based on the conceptual
arbitrage relationship discussed here.
The hedge ratio needed to minimize the residual risk can be derived from
the generalized hedging structure described by Equation 3.12. Taking the

variance of returns and allowing for less-than-perfect correlation between the

returns on the security price, S, and the futures contract price, F, gives
σV2 = σ2S + h 2 σ2F + 2hσ S σ F ρSF , (3.15)
where σ S and σ F are the volatilities of, respectively, the security and futures
contract returns and ρSF is the correlation coefficient between the security
and futures contract returns.
Taking the first derivative of Equation 3.15 with respect to the hedge ratio,
h, and setting the result equal to zero gives the minimum-variance hedge as
σS
h = − ρSF . (3.16)
σF
Substituting Equation 3.16 back into Equation 3.15 gives the variance of the
hedged position as
σV2 = σ2S (1 − ρ2SF ). (3.17)
Thus, if the returns on the security and the futures contract used in the hedge
are perf ectly correlated, so that the value of ρSF is zero, then the variance
of the net exposure in Equation 3.17 is zero, indicating that the risk of the
underlying security can be completely hedged.
In general, correlation between the security and the futures returns will
be less than perf ect, leaving some amount of residual risk. The minimum-
variance hedge converts the price risk of the security into the smaller tracking
error between the security and the futures contract. For example, consider the
simple case in which the risks of the security and futures contracts are equal,
σ S = σ F , so that the optimal hedge in Equation 3.16 is the negative value of
the correlation coefficient, h = − ρSF . If the correlation is less than perfect—
say, ρSF = 0.90 —the optimal hedge ratio is –0.90 and the ratio of hedged
variance to security variance in Equation 3.17 is 1 – 0.902 = 0.19, meaning that
the minimum-variance hedge has only 19% of the variance of the unhedged
position. For a lower correlation—say, ρSF = 0.80 —the remaining variance
is 1 – 0.802 = 36% of the variance of the unhedged position, even af ter the
optimal hedge has been applied.
The minimum-variance hedge ratio is sometimes estimated statisti-
cally by regressing the underlying security returns on the f utures contract
returns. Specifically, the negative of the slope coefficient f rom the regres-
sion produces an estimate of the minimum-variance hedge ratio. Although
this time-series regression technique is often used to estimate the appropri-
ate hedge ratio, care must be taken in interpreting the results. Because the
regression usually incorporates returns for several successive days or weeks,
the regression generally does not account f or the slow but inevitable con-
vergence of the futures contract and the underlying spot price. The typical

regression will calculate a hedge ratio that averages the futures return vari-
ance over the past life of the contract, not the variance at the initiation of
the hedge. Examination of the arbitrage-free futures price as a function of
the underlying spot price in Chapter 2 indicates, however, that changes in
price of the futures when the expiration date on the futures is still far away
will be different f rom changes when the contract is about to expire. For
many cross-hedging applications, this distortion will be small and unim-
portant. But for some applications, such as pure arbitrage against the spot
price, precision will be more critical and the time-series regression analysis
will not be adequate.
Theoretical Hedge Ratios

As discussed in Chapter 2, the arbitrage relationship between a futures con-
tract and the index on which the f utures contract is based keeps the prices
tightly linked together. Here, we show how this arbitrage relationship can be
combined with a measure of an asset’s responsiveness to the underlying index
to determine the optimal hedge ratio. This hedge ratio, together with the
notional value of the futures contract, can then be used to calculate the num-
ber of futures contracts needed for the optimal hedge. We consider theoreti-
cal hedge ratios for three kinds of investor exposures: equity portfolio hedges,
bond hedges, and foreign currency hedges.
Equity Portfolio Hedges. Suppose the price of an investor’s equity port-
folio changes by a factor of β relative to the index used by the futures contract,
∆S = β ∆I , (3.18)
where I represents the index. As shown in Chapter 2, in an arbitrage-f ree
∅F , with respect to the price
market, the price change in the futures contract, ∆
change in the market index, ∆∅II , is given by
∆F = ∆I (1 + r − d ) ,
t (3.19)
where t is the time to contract expiration (measured in years) and r and d are,
respectively, the annualized short-term interest rate and index dividend yield.
Inserting the two relationships in Equations 3.18 and 3.19 into the general
optimal hedge ratio in Equation 3.14 gives
−β
h= . (3.20)
(1 + r − d )t
Together with the notional value of a single f utures contract and the dollar
value of the investor’s portfolio, the optimal hedge ratio in Equation 3.20 can
be used to determine the number of futures contracts to buy or sell.

As an example, consider the calculation of the minimum-variance hedge

ratio and the number of f utures contracts required f or a short-term (e.g.,
three-day) hedge of a $22 million equity portfolio with a beta of exactly 1.0
relative to the S&P 500. If the short-term interest rate is 0.50%, the dividend
yield is 2.50%, and the f utures contract has three months to expiration (t =
0.25), the optimal hedge ratio in Equation 3.20 is
1.0
h=− = −1.005.
(1 + 0.0050 − 0.0250)0.25
Because the f utures contract’s expiration date of three months is well
beyond the short-term investment horizon of three days, the hedge ratio is
not an equal dollar match even when the beta of the equity portfolio is exactly
1.00. Note that the exact value of this optimal hedge ratio can change after
a day or two, but the convergence in basis from one day to the next is quite
small. As shown in Table 1.1, the contract size for the Mini S&P 500 futures
is 50 times the value of the S&P 500. Suppose the index is currently at 1,330,
so the notional value is 50 × 1,330 = $66,500 per contract. Then, the number
of Mini S&P 500 contracts required for an optimal short-term hedge of the
$22 million equity portfolio is
 Value hedged   22, 000, 000 

n = h  = −1.005  = −332.5,
 Contract size   66,500 
where the minus sign indicates a short futures position.

In contrast, if the investor wanted to hedge the risk of the equity portfolio
for three months, the hedge ratio would be 1.000 and the number of contracts
needed would be slightly lower:
 Value hedged   22, 000, 000 
n = h  = −1.000  = −330.8.
 Contract size   66,500 
Note that this difference in optimal hedge ratios depending on the investment
horizon (i.e., three days or three months) may not be considered material relative
to the basis risk in the hedge and, consequently, is often disregarded by investors.
Bond Hedges. To illustrate the hedging of a bond, we will use the
fixed-income concept of duration, similar to using an equity portfolio’s beta in
an equity hedge. The modified duration of a bond, DB* , is defined as the nega-
tive percentage change in bond price, −∆B/B , associated with a change in the
bond’s yield, ∆yB,
∆B
− = DB* ∆yB . (3.21)
B

The minus sign is used in Equation 3.21 because a bond’s price and yield move
in opposite directions. Similarly, the modified duration of a bond futures con-
tract, DF* , is
 ∆F  *
−  = DF ∆yF , (3.22)
 F 
where F represents the f utures price and yF is the yield to maturity of the
futures contract’s cheapest-to-deliver (CTD) bond.
Using the concept of duration as defined in Equations 3.21 and 3.22 in
the general optimal hedge ratio in Equation 3.14 gives
DB*  B   ∆yB 
h=−   . (3.23)
DF*  F   ∆yF 
To illustrate the calculation of this hedge ratio, we will use a $28 million
bond position hedged with T-note f utures. Suppose the f utures price is 133
12/32 (133.375% of par), the bond price is 138 16/32 (138.500% of par), and
the modified durations of the security and the f utures contract are, respec-
tively, 10.3 years and 9.4 years. In this example, we assume that the ratio of
the change in yield to maturity of the bond being hedged to the change of the
future’s contract CTD bond is ∆yB / ∆yF = 0.98.
With these numbers, the optimal hedge ratio in Equation 3.23 is
10.3  138.500 
h =−   (0.98) = −1.115.
9.4  133.375 
As shown in Table 1.1, the notional value of each Treasury note
futures contract is $100,000 times the price of the CTD bond. If the price
of the CTD bond is 132.750% of par, the notional value of each con-
tract is $132,750. So, the optimal hedge on the $28 million bond exposure
would require
 Value hedged   28, 000, 000 
n = h  = − 1.115   = − 235.2
 Contract size   132, 750 
contracts, where, again, the negative value indicates a short futures position.
A concept closely related to duration is DV01, defined as the dollar value
of the change in the fair value of a security or portfolio arising from a 1 bp
change in interest rates. As discussed in the appendix, DV01 is of ten used
instead of more general duration numbers to calculate the number of futures
contracts needed for a hedge.
Foreign Exchange Hedges. As discussed in Chapter 2, the arbitrage-
f ree price of currency f utures depends on the relative values of the domes-
tic and foreign interest rates. Using Equation 2.7, the change in the currency

f utures price given a change in the spot exchange rate (quoted as domestic
currency per foreign currency unit—e.g., USD/EUR), is
t
 1 + rd 
∆F = ∆S   , (3.24)
 1 + rf 
 
where
t = time to contract expiration (measured in years)
rd = domestic short-term interest rate
rf = foreign short-term interest rate
The optimal hedge ratio given in Equation 3.14 applied to the specific
case currency hedges is, therefore,
t
 1 + rf 
h = −  . (3.25)
 1 + rd 
Thus, the optimal hedge ratio will be slightly different from 1.0 for any mate-
rial difference between the two interest rates and a long enough expiration
date for the futures contract.
As an example of how to use currency futures in a short-term hedge, con-
sider a U.S. investor with a €5 million exposure. Suppose the domestic short-
term interest rate is 3.75%, the euro interest rate is 1.25%, and the f utures
contract has six months to expiration. Then, the optimal hedge ratio is
0.50
 1 + 0.0125 
h = −  = −0.988.
 1 + 0.0375 
As shown in Table 1.1, the contract size f or the USD/EUR f utures is
€125,000, so the hedge on a €5,000,000 exposure requires
 Value hedged   5, 000, 000 

n = h  = − 0.988   = − 39.5
contracts, where, again, the minus sign indicates a short futures position.
Controlling Asset Exposure: Asset Allocation

In the previous section, we used the optimal (i.e., risk-minimizing) hedge
ratio in Equation 3.14 to deal with exposures to individual assets or asset
classes. Recall that the general hedging framework in Equation 3.12 defines
the change in the value of a hedged portfolio as the change in the spot price,
∆S, plus the hedge ratio, h, times the change in the future price, ∆F. We close
this chapter by illustrating how this general hedging relationship can be used
to effectively alter the mix of stocks, bonds, and cash in a multi-asset-class
portfolio. The f ramework can be expanded to include the foreign exchange

risk embedded in an international portfolio, although for simplicity, we con-

sider a purely domestic portfolio.
Suppose the investor has a portf olio of stocks, bonds, and cash, with
weights of, respectively, wS , wB , and 1− wS − wB . The stock component of the
portfolio has a beta of βS with respect to the equity index that underlies the
available f utures contract. The bond component has a modified duration of
DB* , and the modified duration of the available fixed-income futures contract
is DF* . Now, suppose the investor would like to alter the asset allocation of the
portfolio to target weights of wTS and wTB for the stock and bond components,
with the target weights set so that the modified duration of the resulting
fixed-income component is DT* . Note that we assume a target beta of 1.0 for
the equity component because if the investor wanted any other equity sensi-
tivity, that result could be achieved simply by choosing a different target
equity weight.
The general hedging f ramework in Equation 3.12 with equity-specific
substitutions from Equations 3.18 and 3.19 produces the relationship
wTS ∆I = wS β S ∆I + hS (1 + r − d )t ∆I , (3.26)
and solving Equation 3.26 for the equity hedge ratio gives
wTS − wS β S
hS = . (3.27)
(1 + r − d )t
Similarly, the general hedging f ramework in Equation 3.12 with bond-
specific substitutions from Equations 3.21 and 3.22 produces the relationship
wTB DT* B∆yB = wB DB* B∆yB + hB DF* F ∆yF , (3.28)

and solving Equation 3.28 for the fixed-income hedge ratio gives
 wT D* − w D*   B   ∆yB 
hB =  B T * B B

 
  F   ∆yF . (3.29)
 DF  
Starting with the composition and risk exposure in the physical assets, the two
hedge ratios in Equations 3.27 and 3.29 allow the investor to alter the stock
and bond composition and risk exposures without modif ying the underlying
physical asset positions. For example, the investor may be a large institution
with active managers in each asset class whose security selection strategies
would be disrupted by a change in the overall allocation of physical assets.
For a numerical example, suppose the investor has a $100 million portfo-
lio composed of 60% ($60 million) stocks, 30% ($30 million) bonds, and 10%
($10 million) cash. Furthermore, the market index beta of the equity compo-
nent of the portfolio is 1.1 and the duration of the fixed-income component
is 8.5 years, compared with 10.3 years for the available bond futures contract.

Suppose the investor would like to target a portfolio of 50% equity and 50%
fixed-income with no cash. Assume the investor’s duration target remains at
8.5 years, the duration that already exists in the fixed-income component of
the portfolio. If the short-term interest rate is 0.50%, the dividend yield on
the index that underlies the equity futures contract is 2.50%, and the nearest
available contract has three months to expiration (t = 0.25), the equity hedge
ratio in Equation 3.27 is
0.50 − 0.60 (1.1)
hS = = −0.161,
(1 + 0.005 − 0.025)0.25
meaning that a short position in equity futures is required.
The actual number of equity f utures contracts needed is equal to the
hedge ratio times the size of the portfolio position, divided by the notional
value of each f utures contract. If the index is currently at 1,330, then one
f utures contract’s notional value is 50 × 1,330 = $66,500. The number of
contracts required to change the exposure of the $60 million physical equity
component of the total portfolio is, therefore,
 60, 000, 000 

n = −0.161  = −145.3,
 66, 500 
or a short position of 145.3 contracts.

The hedge ratio required to adjust the fixed-income component of the
portfolio depends on the relative prices of the average bond in the portfolio
and the price of the fixed-income futures contract. Suppose the average bond
price is 138 16/32 (138.500% of par), the futures price is 133 12/32 (133.375%
of par), and the expected change in yield to maturity of the average bond in
the portfolio is equal to the expected change in yield to maturity of the CTD
bond, so ∆yB/∆y F = 1.0. Then, the fixed-income hedge ratio in Equation 3.29 is
 ( 0.50 )( 8.5 ) − ( 0.30 )( 8.5 )   138.500 
hB =    (1.00 ) = 0.171,
 10.3   133.375 
so a long position in the fixed-income futures is required.
The actual number of fixed-income f utures contracts needed is equal to
the hedge ratio times the size of the portfolio position, divided by the notional
value of the f utures contract. If the price of the CTD bond is 132.750% of
par, the notional value of each contract is $132,750. Then, the number of
contracts required to change the exposure of the $30 million physical fixed-
income component of the portfolio is
 30, 000, 000 
n = 0.171  = 38.6.
 132, 750 

Finally, note that the targeted zero cash position in the portfolio is achieved
by overlaying the existing 10% cash position as part of the bond futures con-
tracts that move the portfolio from 30% to 50% fixed-income exposure.
The principles involved in this asset allocation decision are conceptu-
ally the same as the hedging principles for individual assets developed ear-
lier in this chapter. The ultimate goal is to determine the appropriate number
of f utures contracts required to produce a desired level of exposure to each
underlying risk. Once the futures contracts are in place, the portfolio behaves
as if the physical asset weights had been adjusted to reflect the desired asset
allocation. Complete hedging eliminates all of the systematic risk, although
nonhedgeable idiosyncratic risk and basis risk remain. Complete hedging is
only one end of the hedging spectrum—no hedge at all being the other end,
with a variety of partial hedges in between. Synthetic asset creation effectively
substitutes one kind of asset-class risk for another, and as we have illustrated,
f utures contracts can also be used to implement tactical asset allocation.
Once the investor understands how the futures contract moves relative to the
underlying asset, f utures contracts can be used in a variety of ways to meet
investor objectives and preferences.

4. Option Characteristics and Strategies:
Risk and Return
The two basic types of options are call options and put options. A call option
gives the owner the right to buy a security at a specified price within a speci-
fied period of time. For example, a call option on the S&P 500 Index gives an
investor the right to buy units of the S&P 500 at a set price within a specified
amount of time. In contrast, the put option gives the owner the right to sell
a security at a specified price within a particular period of time. The right,
rather than obligation, to buy or sell the underlying security is what differ-
entiates options from futures contracts. In other words, the option holder has
the right to buy or not to buy, to sell or not to sell, depending on which course
of action the holder deems most advantageous.
In addition to buying an option, investors may sell a call or put option they
have not previously purchased, which is called writing an option. Thus, there
are f our basic option positions, as shown in Figure 4.1. Understanding how
put and call option prices behave and how these basic option positions affect
an overall portfolio is critical to understanding more complex option strategies.
Figure 4.1. Option Positions
Call Option Put Option
Purchased the right to buy the Purchased the right to sell the
Buy
underlying security underlying security
Sold the right to buy the Sold the right to sell the
Sell or
underlying security underlying security
Write
(might be forced to sell) (might be forced to buy)
Option Characteristics
Options have several important characteristics, including the strike or exercise
price specified in the option contract. The exercise price is the value at which
the investor can purchase (with a call option) or sell (with a put option) the
underlying security. The exercise price of a simple option is fixed until expira-
tion, whereas the market price of the underlying asset naturally fluctuates.

Moneyness ref ers to the relationship between the current price of the
underlying security and the option’s exercise price. Specifically, f or call
options, the terms in the money, at the money, and out of the money identif y
whether the underlying security price is currently above, at, or below the
option’s strike or exercise price, respectively. For example, a call option that
has a strike price of $100 when the security price is $120 is in the money
because the holder of the option can buy the security for less than its current
value. For a put option, the terms in the money, at the money, and out of
the money are reversed; they identif y whether the underlying security price
is currently below, at, or above the option’s exercise price respectively. For
example, a put option with a strike price of $100 while the security is priced
at $90 is in the money because the investor can sell the security for more than
its market price. In either case, an in-the-money option is one that currently
has a positive exercise value.
A second important characteristic is the maturity of the option con-
tract, which defines the time period within which the investor can buy
or sell the underlying security at the exercise price. Af ter that date, the
option expires and can no longer be exercised. Option contracts come
in two general types, or styles—those that can be exercised any time up
to and including the exercise date and those that can be exercised only
on the specific maturity date. An option that can be exercised early is
called an American option, whereas an option that can be exercised only on
the maturity date is called a European option. Although this terminology
originated within a geographical context, the style terms are now used
independently of where the option market is located. For example, most
of the options traded on organized exchanges in the United States are
American-style options, although a few European-style options are traded
in the United States.
Another contract specification has to do with adjustments for any divi-
dends or interest paid on the underlying security. An option with a strike or
exercise price that is adjusted for cash distributions is called an option with
payout protection. Most exchange-traded options on individual stocks are not
protected f rom dividend payout but are automatically adjusted f or 2-f or-1,
3-for-1, and other kinds of stock splits.
The price that an exchange-traded option currently trades at, sometimes
called the option’s premium, depends on a number of f actors, including the
difference between the contract’s strike price and the price of the underly-
ing security. In fact, analysts have come to think of the option’s market price
as being composed of two parts—the intrinsic value and the time value—as
illustrated in Figure 4.2.
The intrinsic, or exercise, value of a call option is the amount of
money that would be received if an investor were to exercise the option

Option Characteristics and Strategies: Risk and Return
Figure 4.2. Option Price Components
Option Intrinsic Time

= +
Price Value Value
Security Price (S0) Volatility (σ)

Exercise Price (X) Interest rate (r)
Time to Expiration (T)
Call intrinsic value = max (0,S0 – X)

Put intrinsic value = max (0,X – S0)
to purchase the underlying security at the exercise price and then imme-
diately sell the security at the current market price. In other words, the
intrinsic value depends on the relationship between the current security
price, S 0 , and the exercise price of the option, X. If S 0 – X is positive,
then the call option is said to be in the money and has a positive intrinsic
value. If S 0 – X is negative, the call option is said to be out of the money
and has zero intrinsic value. Thus, the intrinsic value of a call option is
either the dif ference between the security price and the exercise price or
zero, whichever is larger. The intrinsic value of a put option is the reverse:
the maximum of X – S 0 or zero, whichever is larger. For a put, the option
is in the money if X – S 0 is positive; otherwise, the intrinsic value of the
put option is zero.
The difference, or residual, between the total market price of the
option and the current intrinsic value is the time value component of the
option. As shown in Figure 4.2, the time value component of the option
price is a f unction of the underlying security’s expected volatility, σ, the
current level of interest rates, r, and the option’s maturity date or time
to expiration, T. The term time value comes f rom the fact that this com-
ponent of the total option price gradually approaches zero as the option
nears expiration, leaving only the intrinsic value. The convergence of the
total option price to the intrinsic value component at expiration is similar
to the convergence of a f utures contract price to the underlying security
price at expiration.
We will use some option prices for Apple Inc. (ticker AAPL) to illustrate
these concepts. Consider the call and put option prices on Tuesday, 22 March
2012, when AAPL was trading for $614.50 per share. Table 4.1 lists the call

Table 4.1. AAPL Stock Option Prices on 22 March 2012

April Expiration August Expiration
Strike Call Put Strike Call Put
605 23.45 13.90 605 53.50 43.00
610 20.75 16.15 610 51.05 45.55
615 18.20 18.60 615 48.70 48.20
620 15.90 20.30 620 46.45 50.95
625 13.85 24.25 625 44.25 53.75
and put option prices for five strike prices and two expiration dates, 20 April
and 17 August. The first expiration date is about one month away f rom the
March date, and the second expiration date is about five months away. The
quotes in Table 4.1 illustrate several important properties of American-style
option prices.
• A call option should be worth at least as much as its intrinsic value. This
property is best illustrated with an in-the-money option. For exam-
ple, the April expiration 610-strike-price call is in the money with an
intrinsic value of 614.50 – 610 = $4.50, whereas the total price of the
option is $20.75. Thus, the time value component of this option is
20.75 – 4.50 = $16.25, well above zero. In fact, given that the intrin-
sic value is zero for the options that are currently out of the money,
all of the option prices listed in Table 4.1 exceed the option’s intrin-
sic value.
• Call options having the same maturity but with higher strike prices are more
out of the money and thus are worth less. The logic of this characteristic is
that a larger (but less likely) move in the stock price will be needed for
the option with the higher strike price to pay off. For example, the price
of the April expiration 615 call, which is slightly out of the money, is
$18.20, compared with the 610 call price of $20.75. In fact, the call prices
all decline with each increase in strike price for both April and August
expirations in Table 4.1.
• Call options having the same strike price but with longer maturities are more
valuable than those with shorter maturities. In other words, the time value
increases with maturity. For example, the price of the August expira-
tion 610 strike-price call is $51.05 with a time value component of 51.05
– 4.50 = $46.55, compared with the $20.75 price of the corresponding
April expiration call option. In fact, the August expiration option price
is higher than the corresponding April expiration price for all of the call
options in Table 4.1.

The price of a generic call option as a f unction of the underlying asset

price is illustrated in Figure 4.3. Notice that the call price (black line)
increases as the asset price increases and that the intrinsic value (dotted line)
is zero until the asset price exceeds the strike price of the option, X. For
underlying security prices above the strike price, the intrinsic value increases
dollar for dollar with the underlying asset price. The time value component
(vertical distance between the black and dotted lines) reaches a maximum
value at the option strike price and then declines toward zero as the call
option goes further in the money.
As shown in Table 4.1, American-style put option prices have similar
properties to call option prices:
• A put option should be worth at least as much as its intrinsic value. For
example, the April expiration 610-strike-price option is out of the
money because 610 is less than $614.40 and thus has a zero intrinsic
value, but the option price is still positive at $15.15. Like with call
options, the put options’ market prices listed in Table 4.1 all exceed the
intrinsic value component.
• Put options having the same maturity but with higher strike prices are more in
the money and thus are worth more. For example, the slightly in-the-money
615-strike-price put option, which has an intrinsic value of 615 – 614.50 =
$0.50, has a higher price at $18.60 than the 610-strike-price put. In fact,
Figure 4.3. Value of a Call Option
Option Price
Call Price Intrinsic Value
Time Value
X
Underlying Asset Price

the total option price increases with each increase in the strike price for
all the put options in Table 4.1.
• Like call options, put options having the same strike price but with longer
maturities are more valuable than those with shorter maturities. For exam-
ple, the price of the 610-strike-price put option f or August expiration
is $45.55, quite a bit higher than the $16.15 price of the corresponding
April expiration put option.
Figure 4.4 illustrates the value of a generic put option (black line) as a
f unction of the underlying asset price, together with its intrinsic value and
time value. As with the call option in Figure 4.3, the intrinsic value compo-
nent of the put option price is a kinked but piece-wise linear function of the
underlying asset price, whereas the time value component (vertical distance
between the black and dotted lines) reaches its maximum value at the option
exercise price.
Figure 4.4. Value of a Put Option
Option Price
Intrinsic Value Put Price
Time Value
X
Underlying Asset Price
The option-pricing properties we have discussed so f ar are summarized

by the algebraic relationships in Table 4.2. The last entry notes that the
price of an American option should be greater than or equal to the price of a
European option with the same parameters. This property follows f rom the
fact that an American option can do everything a European option can do
and more because it can be exercised early.

Table 4.2. American Option-Pricing Relationships

Call Option (C) Put Option (P)
Minimum option price, intrinsic value max (0, S 0 – X) max (0, X – S 0)
Impact of exercise price (X1 < X 2) C(X1) ≥ C(X 2) P(X1) ≤ P(X 2)
Impact of time to expiration (T1 < T2) C(T1) ≤ C(T2) P(T1) ≤ P(T2)
Early exercise American ≥ European option prices
Several other properties of option prices will be explored in Chapter

5, but we note an additional one here: The percentage change in an option
price is typically much larger than the corresponding change in the underlying
asset price. This so-called implicit leverage is part of what makes options
usef ul f or hedging risk in the underlying asset. But it also means that
the value of the option is quite volatile when held by itself , particularly
in the case of out-of -the money options. For example, the April expira-
tion 620 strike-call option in Table 4.1 has a price of $15.90, based on the
underlying Apple stock price of $614.50. Suppose an investor bought this
option in anticipation of a price rise in Apple shares but then the share
price dropped the next day to $600. The f air price f or this option at the
new lower stock price, assuming no change in the expected volatility of
the stock, turns out to be about $10.00. Thus, the percentage price drop
in AAPL shares is only 600/614.50 – 1 = –2.36%, a small loss. But the
return for the option investor is $10.00/$15.90 – 1 = –37.1%, a much more
substantial loss. Indeed, the magnitude of the loss in the option contract
represents a leverage factor of about 16 to 1 (i.e., 37.11/2.36), much more
leverage than an individual investor could obtain by buying the stock on
margin (i.e., 2 to 1). This kind of price volatility with options is the rule
rather than the exception and entails substantially more volatility than do
positions in the underlying asset.
More insight into the characteristics of options can be obtained by
examining their payoff values at expiration. The contingency table is one
technique for showing the expiration value of various option positions and
strategies. In the following table, we show the individual values of a long
call, a long put, and the underlying security—contingent on whether the
price of security ST is above or below the exercise price on the option expi-
ration date.
ST < X ST > X
Call option 0 ST – X
Put option X – ST 0
Security ST ST

In the first row, the call option has value at expiration if and only if the
underlying asset price is above the strike price, X. In the second row, the
put option has value at expiration if and only if the underlying asset price
is below the strike price, X. In the third row, the value of the underlying
security, ST , is the same whether it is below or above the option’s exercise
price. As the reader will see, contingency tables can be expanded to include
writing (short selling) options and various combinations of options and the
underlying security.
Another usef ul tool f or option analysis is a hockey stick diagram of the
expiration date payoff as a function of the underlying asset price. For example,
Figure 4.5 illustrates the payoff pattern for a call option at expiration. The
horizontal axis is the underlying security price and the vertical axis measures
the gross payoff (solid line) and net payoff (dotted line) of the call option. The
net payoff equals the gross payoff minus the price the investor pays initially to
acquire the option, C.
On the one hand, if the security price ends up below the strike price,
X, the gross payoff to the call option is zero, as shown on the lef t side
of Figure 4.5. On the other hand, if the security price ends up above the
exercise price, the gross payoff to the call option is the difference between
the security price and the strike price, ST – X, as shown on the right side of
Figure 4.5.
Figure 4.5. Payoff Profile of a Call Option
Option Payoff
X
0
–C
Breakeven Point: X + C
Underlying Security Price

Gross Payoff Net Payoff

The net payoff from the call option is a constant negative value until
the security price reaches the exercise price. From that point, the net
payoff (dotted line) starts to rise. The investor breaks even, with zero net
prof it, at the point where the security price equals the strike price plus
the initial price paid f or the option. The investor enjoys a positive net
prof it if the underlying asset price ends up greater than the breakeven
point. Note that the call option payoff has a kinked or asymmetrical pay-
off pattern, which distinguishes it from a futures contract. As the reader
will see, this asymmetry in the payof f allows the option to create spe-
cialized return patterns at expiration that are unavailable when using a
futures contract.
Figure 4.6 is the payoff diagram for a put option. The put option has a
gross payoff of zero if the underlying security price ends up above the exercise
price, as shown on the right side of the figure. If the underlying asset price is
below the strike price, the gross payoff to the put option is X – ST , with the
maximum gross payoff being X if the underlying security price goes all the
way to zero. The net payoff is shown by the dotted line, which is shifted down
f rom the gross payoff by the initial cost of the put option, P. The investor
breaks even, with zero net profit, at the point where the security price equals
the strike price minus the initial price of the put option. The investor in a put
option incurs a net loss if the security price is above that value at the expira-
tion of the option.
Figure 4.6. Payoff Profile of a Put Option
Option Payoff
X
0
–P
Breakeven Point: X – P


Option Strategies
The payoff profiles for buying call and put options, together with the payoff
profiles for selling options, can be used to understand common option strate-
gies. These strategies include covered calls, protective puts, and more compli-
cated option strategies, such as straddles and option spreads. Illustrations of
other common strategies are contained in the exercises section at the end of
this book.
Covered Call. An investor constructs a covered call position by selling
a call option on shares of an underlying security that is already owned. The
following contingency table shows how the value of a covered call depends on
the price of the underlying security at the expiration date:
ST < X ST > X
Security ST ST
– Call option 0 –(ST – X)
Total payoff ST X
The first row of the table shows that the underlying security has a value of ST
at the expiration of the option, independent of whether that price is above or
below the option’s exercise price. The second row shows that the call option
has a value of zero if the underlying security price ends up below the option’s
exercise price. If the underlying security is above the exercise price of the
call, then the option expires in the money with a value of ST – X. Because the
call option has been sold instead of purchased, the payoff requires a negative
sign. Totaling up the columns provides the gross payoff when the security
is either below or above the exercise price at expiration. Specifically, if the
security price is below the exercise price, the covered call position is worth
ST , and if the security price is above the exercise price, the covered call posi-
tion is worth X.
Figure 4.7 illustrates the gross payoff for the covered call, with a dotted
line added for the net payoff, which includes the price received for the call
option that is written or sold. As shown on the diagram, the gross payoff to
the covered call position represented by the heavy solid line is ST until the
underlying security reaches a price of X. For underlying security prices above
X, the gross payoff to the covered call is capped at X no matter how high
the price goes. The dotted line represents the total covered call value when
the premium that was received by selling the call option, C, is also taken
into account. This total, or net, value can then be compared with the payoff
on the underlying security without the added option position, shown by the
lighter solid line in Figure 4.7.

Figure 4.7. Payoff Profile of a Covered Call
X+C
0
X
Breakeven Point: X + C

Payoff on Underlying Security
The benefit of the covered call occurs when the underlying security price
is below the exercise price, in which the total value (dotted line) is consis-
tently a little higher than the value of the security itself . The risk of the
strategy lies above the strike price, in which the covered call does not fully
participate in the market rise. The breakeven point, or net payoff of zero,
occurs when the security price equals the strike price plus the original price
of the call option. Thus, the covered call is not a “free lunch” because there
are ending security prices for which the investor is worse off for having writ-
ten the covered call.
Protective Put. A protective put is constructed by buying a put option,
typically out of the money, on a security that the investor already owns. The
contingency table for the protective put follows.
ST < X ST > X
Security ST ST
Total payoff X ST
The first row of the contingency table shows that the value of the security is
ST whether it ends up being above or below the exercise price on the expira-
tion date. In the second row, the value of the put option is X – ST below the

option’s exercise price and is zero above the exercise price. The total gross
payoff of the protective put strategy is found by adding up the value in each
column, so the protective put is worth X below the exercise price and ST above
the exercise price.
The protective put is depicted graphically in Figure 4.8. The light solid
line represents the security value in isolation, and the heavier solid line
represents the gross payoff to the put option and the security combined.
Below the exercise price, the put option compensates for the lower security
price, so the total gross payoff is constant at a value of X. Once the original
cost of the put option is accounted for, the net payoff is represented by the
dotted line. The breakeven point, or zero net profit, on the protective put
occurs when the security price is equal to the strike price minus the cost of
the put option.
Figure 4.8. Payoff Profile of a Protective Put
X–P
0
X
Breakeven Point: X – P

Payoff on Underlying Security
As shown in Figure 4.8, the benefit of the protective put occurs below
the exercise price, where the combination of security and put option is
worth more than the security itself, thus putting a floor on the value of the
combined package. The option market does not give this downside protec-
tion for free, however, in that above the exercise price, the net value of the
protected put is worth a little bit less than the security. The protective put is
sometimes known as portfolio insurance because the put option protects the

value if the security price falls while maintaining some market exposure if
the price rises.
Straddle. The straddle is an option strategy that involves the purchase
of both a put and a call at a given exercise price but does not include a position
in the underlying security. The contingency table for the straddle follows.
ST < X ST > X
Call option 0 ST – X
Total payoff X – ST ST – X
The call option in the first row has a value of zero below X and a value of ST
– X above X. The put option in the second row has a value of X – ST below X
and a value of zero above X. The total gross payoff shown in the bottom row is
thus X – ST below X and ST – X above X.
The net payoff f or the straddle is illustrated by the dotted line in
Figure 4.9. The breakeven points f or this strategy incorporate the cost
of both the call and put options and are positioned on either side of the
strike price. The investor enjoys a positive profit if the security price moves
away from the strike price and falls outside the breakeven points. In other
Figure 4.9. Payoff Profile of a Straddle
X–C–P
0
X
Breakeven Point: Breakeven Point:

X–C–P X+C+P


words, if the security price makes a big move up or down, the investor
makes money, but the investor loses money if the underlying security price
stays relatively constant.
A straddle can be used when the investor is uncertain about the direction
of a price change in the underlying security but believes that a large change
will occur. As we will discuss in Chapter 5 on option pricing, the straddle
actually makes money, net of the cost of the option, if the underlying asset
price moves more than the volatility estimated by other participants in the
market, as embedded in the option’s time value component.
Bull Call Spread. The bull call spread is constructed by buying a
call option with an exercise price of X1 and simultaneously selling a call
option with a higher exercise price of X 2 . The bull call spread is more
complex than the previous strategies because the position involves more
than one strike price. Because the investor needs to know how the spread
will behave above and below each strike price, the contingency table must
be enlarged into three columns. The contingency table f or the bull call
spread follows.
ST < X 1 X 1 < ST < X 2 ST > X 2

Call option #1 0 ST – X 1 ST – X 1
– Call option #2 0 0 – (ST – X 2)
Total payoff 0 ST – X 1 X 2 – X1
The first row shows that the call option with the lower strike price, X1,
has no value when the underlying security falls below that value. But for
underlying security prices that are greater than X1, this call option is in
the money and has a value of ST – X1, independent of whether the security
price is above X 2 . The second row in the table shows that the call option
sold has no value as long as the underlying security price is less than X 2 .
When the security price is greater than X 2 , the payoff f or this option is
–(ST – X 2), where the minus sign in front of the term indicates this option
has been sold. In the last row, we see that the total payoff at expiration is
zero when the security price is below X1, is ST – X1 when the security price
is between X1 and X 2 , and is X 2 – X1 when the underlying security price is
above X 2 .
The gross and net payoffs to the bull call spread are illustrated graphically
in Figure 4.10. Until the security price reaches X1, the gross payoff is zero.
Above X 2, the gross payoff is X 2 – X1. Between X 2 and X1, the gross payoff is
a diagonal line connecting the two. The dotted line in Figure 4.10 shows the
net payoff that accounts for the cost of the option bought as well as the price

Figure 4.10. Payoff Profile of a Bull Call Spread
X2 – X1
0
X1 X2
C2 – C1
Breakeven Point:
X1 + C1 – C2

received for the option sold. The breakeven or zero net profit point for the bull
call spread is where the security price equals the lower strike price, X1, plus
the net cost of the two call options, C1 – C2. C1 will be more expensive than
C2 because it has a lower exercise price. Thus, loss is limited if the security
price declines, but the gain is also limited if the security price goes up. This
option spread is “bullish” in the sense that the higher payoffs occur when the
security price has gone up.
Pre-Expiration-Date Analysis. To this point in the chapter, we

have examined option strategies f rom the perspective of their terminal
value at the expiration date. Specifically, both the contingency tables and
the payoff diagrams have been based on the combined value of the sepa-
rate elements at the expiration date of the options that are used. Although
somewhat simplistic, these techniques are popular because they allow the
investor to easily keep track of all the individual pieces of the strategy as
well as their combined effect. But many strategies are not held to the expi-
ration date of the options, so some attention to the pre-expiration-date
payoff is also warranted. Drawing profiles of pre-expiration-date payoffs
requires the use of a pricing model to value the option positions at a point
in time prior to expiration, a topic we explore in Chapter 5. For example,
Figure 4.11 illustrates the profit profile of the bull call spread prior to the
expiration of the options. Note that the sharp corners of the payoff profile
are smoothed in comparison with Figure 4.10. As the time to expiration
draws near, the profile becomes sharper and closer to the expiration date
shape shown in Figure 4.10.

Figure 4.11. Net Payoff Profile of a Bull Call Spread before

Expiration
X2 – X1
X1 X2
0
C2 – C1

Before Expiration At Expiration
Choosing a Strategy
The choice of an option strategy depends on at least two investor perspectives—
on the direction (up or down) of the price change for the underlying security
and on the cost (cheap or expensive) of the options. Figure 4.12 shows how
these two perspectives inf orm the type of option (put or call) in which the
investor might take a position and whether to buy or sell them.
First, on the vertical axis, when an investor is bullish on the underlying
security, the best strategies generally involve buying call options and/or sell-
ing put options. When the investor is bearish on the underlying security, the
best strategies generally involve buying puts and/or selling calls.
The second dimension relates to the cost of the options, which under
arbitrage-f ree pricing comes down to the investor’s belief about the volatility
of the underlying security. On the one hand, if the investor believes the actual
volatility of the underlying security will be low relative to market expectations,
then the options will seem expensive and the investor will generally want to sell
rather than buy them. On the other hand, if the investor believes the actual vola-
tility of the underlying security will be high relative to market expectations, then
the options will seem cheap and the investor will generally want to buy rather
than sell them. For example, if the investor is bearish and the options are not
expensive, buying put options outright or using a protected put strategy with
the underlying security is attractive. If the investor is neutral in terms of market
direction and the options are expensive, selling a straddle (selling both a put and
a call) or taking other kinds of “short volatility” positions can be attractive. Thus,
expectations of both the direction and the volatility in the underlying security
help investors establish a framework within which to develop option strategies.

Figure 4.12. Option Strategies: Perspective on Market Direction and

Option Price
Buy Calls
Sell Puts
Market Up
Options Options
Buy Options Sell Options
Cheap Expensive
Market Down
Buy Puts
Sell Calls
The choice of strike prices on the options and the choice of option matu-
rity also come into play, but the two most important considerations relate to
the investor’s view on the direction of change in the underlying security price
and the investor’s view on volatility. Specifically, given general informational
efficiency of financial markets, what really matters is the investor’s view on
the value and volatility of the underlying security relative to the view of other
market participants. In Chapter 5, we develop tools to determine the volatility
of the underlying security that is implied by any given option price.
Probability Distribution of Returns

The contingency tables and payoff diagrams we have used to this point pro-
vide perspective on the range of potential payoffs to various option strategies
but do not account for the probability of any specific payoff actually occur-
ring. For example, in accordance with a typical bell-shaped probability dis-
tribution, small changes in the underlying security price between the time
an option is purchased and the time it is sold are clearly more likely than
large price moves. The probability distribution of returns to an option strategy
depends not only on the probability distribution of the underlying security
but also on the configuration of options selected.
For example, consider the covered call strategy of selling call options on
an individual security that the investor already owns. The solid line in Figure
4.13 shows a typical lognormal probability distribution of one-month returns on
an individual stock, with a mean return of 1% and standard deviation of 10%.
The dotted line shows how the probability distribution is affected by selling call
options that are 10% out of the money to cover 50% of the underlying secu-
rity position. The light solid line shows the impact of selling enough call options
to cover 100% of the security positions. Note how the shape of the probability

Figure 4.13. Probability Distribution for a Covered Call
Probability Index
8
0
–40 –30 –20 –10 0 10 20 30 40
Return (%)
0% Covered Call (underlying security)

50% Covered Call 100% Covered Call
distribution changes as an increasing proportion of call options are sold relative

to the underlying security position. Selling call options draws the return distri-
bution back on the right side, thus increasing the chance that an investor will
receive only moderate returns. The light solid curve shows that selling call options
on 100% of the underlying security position completely truncates the right side
of the probability distribution at 11%, based on the 10% out-of-the-money strike
price plus an additional 1% return from the proceeds of selling the call.
Figure 4.14 illustrates how the probability distribution is affected by buy-
ing protective puts that are 5% out of the money. Buying put options on 50% of
the underlying security position truncates the left side of the probability distri-
bution and increases the probability of moderate returns. On the right side of
the distribution, the cost of the protective put is evidenced by a slightly lower
probability of achieving any particular return, in that the dotted line is slightly
below the dark solid line. Figure 4.14 also shows that purchasing protective
puts on 100% of the security portfolio completely truncates the left side of the
distribution at –7%, based on the –5% strike price of the put options minus 2
additional percentage points of total return for the cost of the options.
Figure 4.15 illustrates the effect of simultaneously selling call options and
buying put options on an underlying stock position, where in this example
the cost of the puts slightly exceeds the proceeds from selling the calls. The

Figure 4.14. Probability Distribution for a Protective Put
Probability Index
8
0
–40 –30 –20 –10 0 10 20 30 40
Return (%)
0% Protective Put (underlying security)

50% Protective Put 100% Protective Put
Figure 4.15. Distribution for a Protective Put and Covered Call
Probability Index
8
0
–40 –30 –20 –10 0 10 20 30 40
Return (%)
0% Covered (underlying security)

50% Covered 100% Covered

combination causes a truncation of the return probability distribution in both

tails. The key concept revealed by these diagrams is that the asymmetrical
nature of option payoffs allows an investor to shape and mold the probability
distribution by truncating some parts and adding to others. In general, call
options affect the right tail the most and put options affect the left tail.
Mean–Variance Performance Comparisons

Common perf ormance metrics in portf olio management depend on the
expected return and risk of a strategy, where risk is measured by the variance
or standard deviation of return. In general, such tools as risk–return diagrams
and Sharpe ratios are less pertinent to option strategies because of the highly
skewed nature of the probability distributions. For example, the probability
distribution for the underlying security in Figure 4.14 is generally symmetri-
cal, indicative of a one-month return on a common stock. The probability dis-
tribution for the full protective put strategy in Figure 4.14, however, is highly
asymmetrical, so standard deviation does not tell the whole story. As a result,
the f amiliar risk–return diagrams f rom mean–variance portf olio theory do
not give a complete picture of option strategies.
For an illustration, consider the diagram for one-month expected return
versus risk in Figure 4.16. The slope of the straight line in Figure 4.16 is based
Figure 4.16. Risk–Return Tradeoffs for Option Positions
Expected Return (%)

1.6
0%
1.5
25% 0%
Covered Call Strategy
1.4 50%
25%
Protective Put Strategy
75%
1.3 50%
1.2
75%
1.1
8.0 8.5 9.0 9.5 10.0 10.5
Return Standard Deviation (%)

on the Sharpe ratio of the underlying stock without any modifications f or

option strategies. As the covered call strategy shown in Figure 4.13 is used,
the expected return and risk decline—but not in a linear fashion. For example,
the 50% covered call strategy appears to have a superior risk–return position
than the completely unhedged (0% covered call) position. The protective put
strategy in Figure 4.14 appears to have an inferior risk–return tradeoff. But
both perspectives are misleading because of the highly asymmetrical nature
of the probability distributions shown in Figure 4.13 and Figure 4.14, which
are not completely captured by standard deviation.
As the reader will see in Chapter 5, the expected return to a fairly priced
option is simply some multiple of the expected return on the underlying secu-
rity. For example, the short-term expected excess return f or buying a call
option might be five times the expected excess return on the underlying stock.
Thus, the mean or expected return on options simply reflects basic leverage
on long and short positions in the underlying security and is not the problem.
The problem is that measuring risk by standard deviation, as in the denomina-
tor of the Sharpe ratio, provides an incomplete perspective on risk. Adequate
perspective on the risk of option-based strategies requires an examination of
the entire probability distribution of returns in either graphic or tabular form.
For example, Table 4.3 shows the probability of returns falling in various
ranges for the underlying stock and for the 100% covered call and protective
put strategies illustrated in Figures 4.13 and 4.14. As shown in Table 4.3,
the covered call strategy has a high probability of moderate returns in the
Table 4.3 Comparison of Return Range Probability

Percentage Underlying Covered Protective
Return Range Stock Call Put
Below –25 0.1% 0.0% 0.0%
–25 to –20 0.9 0.2% 0.0
–20 to –15 3.3 0.8 0.0
–15 to –10 8.3 2.3 0.0
–10 to –5 14.6 4.3 82.7
–5 to 0 19.1 6.0 5.2
0 to +5 19.1 6.3 4.7
+5 to +10 15.2 5.2 3.5
+10 to +15 9.9 74.9 2.1
+15 to +20 5.4 0.0 1.1
+20 to +25 2.6 0.0 0.5
Above +25 1.6 0.0 0.3
Total 100.0% 100.0% 100.0%

+10% to +15% range but no probability of larger returns. But the protective
put strategy has no probability of returns below –10% and preserves some
probability of high returns. Like the probability distribution diagrams them-
selves, the tabulation of the range of return probabilities gives some idea of
what tradeoffs are being made in the strategies, but the investor must still
decide which tradeoffs are preferred. To summarize, option strategies cause
distortions to standard symmetrical return distributions that are large enough
to make mean–variance comparisons erroneous.

5. Option Contracts: Pricing Relationships
Options are derivative securities, so the price of an option depends on the

value of the underlying security, but it also depends on several other f ac-
tors. We explore a number of arbitrage-based relationships and then intro-
duce formal option valuation methodologies, including binomial pricing and
the Black–Scholes model. Profitable strategies that are essentially risk f ree
restrict the price of options within specific bounds. Thus, the market price of
an option contract, similar to that of a f utures contract, is ultimately driven
by the principle of arbitrage. As we noted in discussing futures contracts, the
arbitrage-based price of an option is not directly dependent on the expected
future price of the underlying security, only indirectly as reflected in the cur-
rent price of the underlying security.
Lower-Bound Adjustments for Put and Call Options

In this section, we will distinguish between the prices of American options,
C0 and P0 (upper case), and the prices of European options, c0 and p0 (lower
case). In Chapter 4, we explained why the price of an American option should
at least be equal to its intrinsic or exercise value, specifically C0 ≥ S0 – X,
where S0 is the current price and X is the exercise price of the option. In fact,
the minimum price boundary for an American call is a bit higher than that.
To derive the higher boundary, consider the strategy of buying a European
call and simultaneously investing in cash amounting to
X
+ D,
(1+ r )T
where r is a risk-free annualized rate and D is the present value of any divi-
dends paid by the security bef ore option expiration at time T. The contin-
gency table for the payoff at expiration to this portfolio follows.
ST < X ST > X
European call option 0 ST – X
T T T
Cash = X/(1 + r) + D X + D(1 + r) X + D(1 + r)
T T
Total payoff X + D(1 + r) ST + D(1 + r)
As shown in the bottom row, the total payoff under either contingency is
equal to or greater than the value of the underlying security together with
dividends at expiration. Thus, the initial price for establishing the portfolio
must be greater than the initial price of the underlying security,

X
c0 + + D > S0 . (5.1)
(1 + r )T
Rearranging terms in Equation 5.1, we have a minimum price limit for the
European call option:
 X 
c0 > ( S0 − X ) +  X −  − D. (5.2)
 (1 + r )T
 
The last part of Equation 5.2 shows that if we disregard any dividends, the
European call option will always be worth more than its intrinsic value,
S0 – X. Because an American option is always worth at least as much as
a European option, this condition must also be true f or an American call
option. But with a large enough dividend, the European call option could
be worth less than its intrinsic value without any way to capture the intrinsic
value by early exercise.
If we define the time value of an option to be equal to the difference
between the option price and the intrinsic value, we can write the time value
for a call option using Equation 5.2 as
 X 
c0 − ( S0 − X ) =  X −  − D + Ic , (5.3)
 (1 + r )T 
where the term in brackets represents the interest opportunity cost of the exer-
cise price between now and the expiration of the option. We use Ic to repre-
sent the “insurance value” of the call option in order to make Equation 5.2 an
equality. The insurance value comes from the fact that a call option benefits if
the price of the security moves up but the loss is limited if the security moves
down. Unless expected cash distributions are large relative to the interest
opportunity cost and the insurance value, the time value will be positive.
For a numerical illustration, consider the f ollowing parameters f or a
European call:
S 0 = $105 X = $100 r = 1.8%

T = 1/12 (one month) c 0 = $7.75 D = $0
The intrinsic value component of this call option is 105 –100 = $5.00, so the time
value component of the $7.75 total price is $2.75. The time value component of
$2.75 can be further decomposed into an interest opportunity cost of 15 cents,
X $100
X− = $100 − = $0.15,
(1 + r )T (1 + 0.018)1/12
and the remaining insurance value of the call, Ic = $2.60.

Option Contracts: Pricing Relationships
To examine a similar lower bound for a put option, consider the contin-
gency table for a portfolio composed of a European put option and the security.
ST < X ST > X
European put option X – ST 0
T T
Security ST + D(1 + r) ST + D(1 + r)
T T
Total payoff X + D(1 + r) ST + D(1 + r)
The portfolio payoff under either contingency is greater than or equal to the exer-
cise price and the future value of dividends, so the current portfolio value must be
worth more than the present value of the exercise price and the dividends:
X
p0 + S0 > + D. (5.4)
(1 + r )T
Rearranging terms in Equation 5.4 gives us a minimum price limit for the
European put option as
 X 
p0 > ( X − S0 ) + D −  X − . (5.5)
 (1 + r )T 
This condition must also be true f or an American put option because it is
always worth at least as much as a European put option. Depending on the
time to maturity and the level of interest rates, the European put option price
may or may not be greater than the intrinsic value, X – S0. Indeed, a European
put option that is deep in the money may have a negative time value without
any way to cash in on the intrinsic value by early exercise.
Using Equation 5.5, we can write the time value of a European put
option as
 X 
p0 − ( X − S0 ) = D −  X −  + Ip, (5.6)
 (1 + r )T 
where the term in brackets again represents the interest opportunity cost of
the exercise price of the option between now and expiration. The term in
brackets is preceded by a negative sign because the potential receipt of the
exercise price earlier rather than later allows the investor to earn interest on
that amount. We use Ip to represent the insurance value of the put option in
order to make Equation 5.5 an equality. The insurance value comes from the
fact that the put option benefits if the price of the security moves down but
the loss is limited if the security moves up.
To illustrate, suppose the underlying security in the preceding example
dropped from $105 all the way down to $80. Now, the pricing parameters are

S 0 = $80 X = $100 r = 1.8%

T = 1/12 (one month) D = $0 p 0 = $19.95
At an underlying security price of $80, the intrinsic value of the put option
is 100 – 80 = $20.00, so the time value component is –$0.05, or negative five
cents. Specifically, the time value component of the European put price is
composed of –$0.15 of interest opportunity cost plus the insurance value of
the put option, $0.10. This example shows that the time value might actually
be negative for the put option if it cannot be exercised early. We will examine
the possibility of early exercise for deep in-the-money puts later in this chapter.
Put–Call Parity for European Options

Another important pricing restriction, specific to European options, is the arbi-
trage relationship known as put–call parity. To understand this relationship, con-
sider a portfolio composed of buying the underlying security, buying a European
put option on that security, and simultaneously selling a European call option
with the same expiration date and strike price. The contingency table follows.
ST < X ST > X
T T
Security ST + D(1 + r) ST + D(1 + r)
European put option X – ST 0
– European call option 0 – (ST – X)
T T
Total payoff X + D(1 + r) X + D(1 + r)
The total payoff to this portfolio at expiration is X + D(1 + r)T, no matter what
the security price is at time T. Because the payoff is certain, the upfront cost
of this portfolio at Time 0 must be the present value of X based on a risk-free
rate, r, plus dividends, or
X
+ D = S0 + p0 − c0 . (5.7)
(1 + r )T
Note that the relationship in this arbitrage argument is a strict equality, not
simply a minimum or maximum limit on option prices. Rearranging the terms
in Equation 5.7 gives the spread between the current price of a European call
option and a European put with the same strike price and expiration date as
X
c0 − p0 = S0 − D − . (5.8)
(1 + r )T
The relationship involves the price of the underlying security, the present
value of any dividends to be paid before expiration, and the present value
of X.

As the reader will see later on, one can rearrange this put–call parity rela-
tionship in various ways for additional insights. Strictly speaking, this arbi-
trage relationship holds only for European put–call pairs. If this relationship
did not hold, then one could create greater-than-riskless returns without any
risk by selling the expensive combination of assets and buying the cheap com-
bination. Thus, put–call parity is analogous to the cash-and-carry arbitrage
condition for futures contracts, also known as spot–futures parity.
Early Exercise of American Options

By contract specification, American options can be exercised early. Although
early exercise is generally not desirable, there are notable exceptions. Specifically,
investors who want to terminate an option position early will typically receive
more money from selling the option than from exercising it. The fact that the
current market price of the option generally exceeds its intrinsic value leads to
the saying that the option is “worth more alive than dead.”
The lower bound for the price of an American call option was suggested
in Equation 5.2 as
 X 
c0 > ( S0 − X ) +  X −  − D. (5.9)
 (1 + r )T 
Assuming for a moment that no dividends are expected before expiration (D = 0),
the price of the American call option must be greater than the intrinsic value, S0 –
X, because for a positive interest rate, X is greater than X/(1 + r)T. In other words,
without any expected dividends, there is no incentive to exercise the American call
option early because selling the option to someone else gives the investor greater
value than exercising it and receiving only the intrinsic value. Early exercise of
an in-the-money call option may be desirable, however, just before a relatively
large cash distribution on the underlying security. Individual stock options in the
United States are not dividend protected, meaning that the strike price does not
automatically adjust for the natural drop in stock price on the ex-dividend date.
We can gain some insight into possible early exercise of an in-the-money
American call option when dividends are expected by using the put–call par-
ity relationship in Equation 5.8. Rearranging the European put–call parity
relationship gives
 X 
( S0 − X ) − c0 = D −  X −  − p0 . (5.10)
 (1 + r )T 
The intrinsic value of a European call option, S0 – X, will exceed the European
call price, c0, if D > X – X/(1 + r)T + p0. If the expected dividend is large
enough, it might be desirable to exercise the option in order to capture the
intrinsic value. In other words, early exercise of a call option may be optimal

if a pending dividend on the underlying stock exceeds the time value compo-
nent, composed of the interest opportunity cost, X – X/(1 + r)T, and the price
of a European put option. This statement suggests the possibility of desirable
early exercise, but it is only an approximation because we have used European
options, not American options, to derive the insight.
For example, the numerical illustration in the preceding section started
with a call option that was $5 in the money. The call option price was $7.75,
with an exercise value of $5.00 and a time value component of $2.75. The
time value included an interest opportunity cost of $0.15 and an insurance
value of the call option (approximated by the price of a European put option)
of $2.60.
Thus, if this stock were going to pay a cash dividend of $2.75 per share
or higher, early exercise of the call option might be optimal just before the
ex-dividend date. Intuitively, the dividend needed to trigger the early exercise
of a call option needs to be higher if prevailing interest rates are higher. For
example, if the interest rate were 5.0% instead of 1.8%, the time value com-
ponent of the $5 in-the-money call option would be $2.92 instead of $2.75.
We can also gain some insight about the possibility of early exercise for an
in-the-money American put option f rom the put–call parity relationship for
European options. Rearranging the relationship in Equation 5.8 gives
 X 
( X − S0 ) − p0 =  X −  − ( c0 + D ) . (5.11)
 (1 + r )T 
The exercise value of a put option, X – S 0, will exceed the European put price,
p0, if c0 + D < X – X/(1 + r)T. In other words, early exercise of an American put
option might be desirable if it is so deeply in the money that a European call
option with the same strike price plus the present value of expected dividends
is less than the present value of the interest opportunity cost. Again, this
statement is only an approximation because we have used European options
and not American options to derive the insight.
For example, early exercise would have been profitable in the preceding
numerical example for a put option with a strike price of $100 on a stock that
had fallen to $80. Specifically, the insurance value of the put option (approxi-
mated by the price of a European call option) was worth only $0.10 but the
interest opportunity cost on the strike price for one month was $0.15. In fact,
sensitivity analysis f or a volatility estimate of 40.0% and the Black–Scholes
option-pricing formula (to be discussed later in this chapter) show that early
put option exercise could be optimal with these parameter values for any stock
price below about $81. Of course, given higher interest rates or more time to
expiration, the interest opportunity cost would be higher and the put option
might not need to be so f ar in the money. For example, sensitivity analysis

shows that if annualized interest rates were at 5.0%, instead of 1.8%, then the
breakeven early exercise stock price would be about $85 instead of $81.
We note again that the numerical examples of early exercise of American
options have only been approximate because American option prices do not
strictly conform to the European put–call parity condition. Specifically, the
prices of American options are affected by the potential for early exercise even
when they are currently out of the money. Our simple analysis suggests that
exercising American options early may be advantageous, but the exact tim-
ing for early exercise is beyond the scope of the analysis here and generally
requires the use of a specific option-pricing model for American options. The
important concepts are that (1) it may be desirable to exercise an American
call option early if an expected dividend is large and (2) it may be desirable to
exercise an American put option early if it is deep enough in the money.
Put–Call Parity Bounds for American Options

Although the exact put–call parity relationship does not apply to American
options, we can use the relationship to derive upper and lower bounds. To
derive the lower bound, consider the payoff f or a portf olio that contains a
European call option, cash equal to X + D, shorting the underlying secu-
rity, and selling an American put. Consider first the case if the American
put option is held to expiration. If the put option is not exercised early, the
contingency table for the portfolio gives a fixed positive payoff as follows.
ST < X ST > X
European call option 0 ST – X
Cash = X + D (X + D)(1 + r) T
(X + D)(1 + r)T
– Security – ST – D(1+ r)T – ST – D(1+ r)T
– American put option – (X – ST) 0
Total payoff X(1 + r) – X
T
X(1 + r)T – X
With a fixed total payoff at expiration and a positive interest rate, the initial
value of the portfolio would have to be positive to avoid a riskless return with
no initial investment:
c0 + X + D − P0 − S0 > 0 . (5.12)
If the American put option is exercised early at some time t, the value of
the position would be
ct + ( X + D)(1 + r )t − St − Dt − ( X − St ) 
 
(5.13)
T t
= ct + X (1 + r ) − 1 +  D (1 + r ) − Dt  ,
   

where ct represents the value of the European call option at time t when the
American put is exercised and Dt represents the value of the dividends paid by
the security to that point. This payoff would be positive, which suggests that
the initial value of the portfolio would also have to be positive whether the
put option was exercised early or not.
Rearranging terms in the inequality f or the initial portf olio value and
using the fact that C0 ≥ c0 gives a lower bound for the difference between the
American call and put options:
C0 − P0 > S0 − X − D. (5.14)
To derive the upper bound for the difference between American call and
put options, we begin with the put–call parity relationship for European options
as given in Equation 5.8. If no dividends are expected to be paid before expira-
tion, the American call option is worth the same as the European call, C0 = c0.
We also know that the American put option is worth at least as much as the
European put, P0 ≥ p0, so with a potentially larger American put price we have
X
C0 ( w/o dividends) − P0 ( w/o dividends) ≤ S0 − . (5.15)
(1 + r )T
With expected dividends, the lower bound f or the American call price is
smaller, and the lower bound f or the put price is larger than without divi-
dends. Consequently, the inequality without dividends will hold even with
expected dividends, so the upper bound for the difference between American
call and put options with or without expected dividends is
X
C0 − P0 ≤ S0 − . (5.16)
(1 + r )T
Therefore, the upper and lower bounds for the American option put–call par-
ity relationship using Equations 5.14 and 5.16 are
X
S0 − X − D < C0 − P0 ≤ S0 − . (5.17)
(1 + r )T
Note, however, that the relationship is not an exact equality as it is f or
European options.
The pricing relationships for put and call options covered so f ar in this
chapter can be summarized as follows.
Call Option Put Option
American intrinsic value C0 = max(0, S0 − X ) P0 = max(0, X − S0 )

European lower bound c0 > S0 − X /(1 + r )T − D p0 > X /(1 + r )T + D − S0
American lower bound C0 ≥ c0 (equality for D = 0) P0 ≥ p0

The put–call parity relationships may be summarized as follows.
European put–call parity c0 − p0 = S0 − X /(1 + r )T − D
American put–call parity S0 − X − D < C0 − P0 ≤ S0 − X /(1 + r )T
The Binomial Pricing Model

In the absence of dividends, option prices depend on the price of the underly-
ing security, the strike price, the volatility of the underlying security, the level
of interest rates, and time to expiration. Understanding the impact of each
of these factors requires a model of the option price, not simply an arbitrage-
restricted price range. In this section, we introduce a simple binomial option-
pricing argument that will provide a specific price f or both call and put
options. As with other derivative securities, the pricing logic will be based
on an arbitrage relationship between the current price of the option and the
underlying security, not a forecast of where the security price will be in the
future. Although the single-period binomial pricing example in this section is
simple, the reader will see in later sections that the binomial branching logic
can be expanded into a more realistic multiperiod setting.
First, consider a call option. Suppose the underlying stock currently has
a price of S0 and can only move up to a price of Su or down to a price of Sd at
option expiration. Figure 5.1 displays the current price and two possible out-
comes for the underlying stock and the call option in this simple “binomial
Figure 5.1. Simple Binomial Pricing Model for a

Call Option
Security Su
S0
Sd
Call Option Cu = max(Su – X, 0)
C0
Cd = max(Sd – X, 0)

price” world. Assuming that the “up” price of the stock, Su, is higher than the
call option exercise price, X, the exercise value of the call option if the stock
goes up will be
Cu = Su − X . (5.18)
If the stock price goes down, the exercise value of the call option, Cd , will
either be zero or a positive value, Sd – X, depending on whether X is above or
below the “down” price of the stock, Sd .
Now, consider a strategy in which the investor buys the underlying secu-
rity and simultaneously sells a call option. Specifically, we will buy a f rac-
tion, hC , of the underlying stock, so that the upfront price for the strategy is
hCS0 – C0. The minus sign in front of the current call price acknowledges that
the proceeds from selling the call option offsets some of the price paid for the
underlying stock. If the stock price goes up, the payoff to this strategy will be
hCSu – Cu , and if the stock price goes down, the payoff will be hCSd – Cd . We
want to strategically choose the fraction hC so that the payoff will be the same
no matter which way the stock price moves. Setting the two possible payoffs
equal to each other and solving for the hedge ratio, hC , gives
Cu − Cd
hC = . (5.19)
Su − Sd
Intuitively, the value of hC in Equation 5.19 is the range of possible option
payoffs divided by the range of possible stock prices and f orms a complete
hedge. In fact, the hedge ratio hC given in Equation 5.19 is analogous to the
delta of a call option in the Black–Scholes model we discuss later.
Because the payoff to this hedged strategy is the same no matter which
way the stock price goes, one could borrow the funds needed to set it up and
then use the certain payoff to settle the loan. As a result, the market will force
the cost of the strategy to be equal to the present value of the eventual payoff.
If the cost were lower, arbitrageurs could borrow money at the risk-free rate
and make an easy profit when the payoff occurred. If the cost were higher,
arbitrageurs could simply “short” or reverse the positions in the strategy and
do the same thing. Thus, arbitrage-free pricing dictates that
hC Su − Cu
hC S0 − C0 =
(1 + r )T
and (5.20)
hC Sd − Cd
hC S0 − C0 = .
(1 + r )T
Note that the value of hC has been specifically chosen so that the even-
tual payoff to this strategy is the same whether the stock goes up or down.

Solving f or the current price of the call option using either equality in
Equation 5.20 gives
qCu + (1 − q )Cd
C0 = , (5.21)
(1 + r )T
where the new variable q is defined as
S0 (1 + r )T − Sd
q = . (5.22)
Su − S d
Although the value of C0 may be expressed algebraically in a number of
ways, Equation 5.21 is particularly useful in understanding the more involved
models of option pricing. Specifically, the use of the variable q makes the
call price algebraically equivalent to a probability-weighted average of two
possible call payoffs, discounted at the risk-f ree rate. Thus, the variable q is
analogous to a “risk-neutral” probability, or the probability that would apply
in a world where investors were unconcerned about risk.
For a numerical illustration of single-period binomial option-pricing
logic, consider the following set of values. The riskless rate of interest is r =
5%; the time to option expiration is one year, T = 1; the current stock price is
S0 = $50; and the strike price of the call option is X = $60. At option expira-
tion, the stock price might go up to Su = $65 or down to Sd = $45. If the stock
price goes up, the call option will expire in the money and the value of Cu will
be max($65 – $60,0) = $5. If the stock price goes down, the call option will
expire out of the money and the value of Cd will be max($45 – $60,0) = 0.
Using Equation 5.19, we find the hedge ratio to be
5−0
hC = = 0.25,
65 − 45
meaning that only 0.25 shares of stock are needed to offset the spread of pos-
sible call option payoffs.
Specifically, if we buy 0.25 shares of stock and simultaneously sell the
call option, the payoff will be hCSu – Cu = 0.25(65) – 5 = $11.25 if the stock
price goes up and hCSd – Cd = 0.25(45) – 0 = $11.25 if the stock price goes
down. Because the payoff of $11.25 is known with certainty, the upfront cost
of the strategy must be its present value, 11.25/1.05 = $10.71 (rounding to the
nearest cent). Because the upfront cost of the shares is 0.25(50) = $12.50, the
proceeds from the call option we sell must be 12.50 – 10.71 = $1.79. We can
confirm the $1.79 call price calculation directly by using Equations 5.21 and
5.22. According to Equation 5.22, we have
S0 (1 + r )T − Sd 50(1 + 0.05) − 45
q= = = 0.375,
Su − S d 65 − 45

so the price of the call option in Equation 5.21 is
(0.375)5 + (1 − 0.375)0
C0 = = $1.79.
1.05
This numerical example illustrates a subtle but important derivatives

pricing concept: The forecasted or expected return on the underlying secu-
rity does not directly affect the arbitrage-free price of the call option. Note
that in determining the price of the call option, we never had to specify the
actual probabilities that the stock price would go up or down. For exam-
ple, it might have been a 50/50 chance, so the expected or probability-
weighted average ending price of the stock would have been (0.5)65 +
(0.5)45 = $55, which is an expected return of 55/50 – 1 = 10%. The up/
down probabilities could as easily have been 60/40, however, in which case
the expected ending stock price would have been (0.6)65 + (0.4)45 = $57
and the expected return would have been 57/50 – 1 = 14%. No matter what
the up/down probabilities actually are, the arbitrage-free price of the call
option remains $1.79.
The algebraic f orm of Equation 5.21 simply suggests that the up/
down probabilities in the underlying stock can be thought of as 0.375
and 1 – 0.375 = 0.625. If those were the actual probabilities, the expected
price of the stock would be (0.375)65 + (0.625)45 = $52.50, f or an
expected stock return of only 52.50/50 – 1 = 5%, the risk-free rate. This
algebraic equivalence is the essence of what is called risk-neutral pric-
ing in the more formal option-pricing models. It seems counterintuitive
that a risky stock should have an expected return that only matches the
risk-f ree rate, but this assumption serves as a shortcut to calculate the
arbitrage-free option price.
The simple binomial pricing argument for a put option is similar to the
pricing argument for a call, as illustrated in Figure 5.2. Again, the secu-
rity price can move up or down and the payoff of the put option is Pu or Pd.
The setup analogous to the call option hedge is to buy hP shares of the stock
and simultaneously buy a protective put for a total upfront cost of hPS 0+ P 0.
Note that the sign in front of the put price in this setup is positive instead
of negative because we are now buying rather than selling the option. The
two possible payoffs to this hedge are hPSu + Pu and hPSd + Pd, and the hedge
ratio that ensures the two payoffs are equal is
Pu − Pd
hP = − . (5.23)
Su − Sd
Note that Equation 5.23 for the put hedge ratio has a negative sign, but
the value will actually be nonnegative because Pu is always less than or equal

Figure 5.2. Simple Binomial Pricing Model for a

Put Option
Security Su
S0
Sd
Put Option Pu = max(X – Su , 0)
P0
Pd = max(X – Sd , 0)
to Pd . For example, using the numerical example, we have a stock price of
either Su = $65 or Sd = $45. If the stock price goes up, the put with a strike
price of $60 expires out of the money with a value of Pu = max(60 – 65,0) = 0.
If the stock price goes down, the put option expires in the money with a value
of Pd = max(60 – 45,0) = $15. Thus, the hedge ratio for the put option is
0 − 15
hP = − = 0.75,
65 − 45
meaning that the hedge is formed by purchasing 0.75 shares of the security
for each put option purchased.
As with the call option hedge, the eventual payoff is, by design, certain,
so the upfront cost must be the present value of the payoff discounted at the
risk-f ree rate. Again, with several steps of algebra, solving f or the current
price of the put option gives
qPu + (1 − q ) Pd
P0 = , (5.24)
(1 + r )T
where q is defined as in Equation 5.22. Using Equation 5.24, we find the
direct calculation of the put option price to be
(0.375)0 + (1 − 0.375)15
P0 = = $8.93.
1.05
As with the call option price, however, this formulation illustrates that the
option price calculation is equivalent to the present value of the risk-neutral

probability-weighted average option payoff. But the underlying logic of this

arbitrage-free price is that the payoff to the hedge position is
hP Su + Pu = 0.75 ( 65 ) + 0 = $48.75
if the stock price goes up and
hP Sd + Pd = 0.75 ( 45 ) + 15 = $48.75
if the stock price goes down. Because the payoff of $48.75 is known with
certainty, the upfront cost of the strategy must be the present value (rounding
to the nearest cent) of 48.75/1.05 = $46.43. Because the upf ront cost of the
shares is 0.75 × 50 = $37.50, then the price of the put option must be 46.43 –
37.50 = $8.93.
We close this section by noting that these call and put option prices are
consistent with the European put–call parity condition. Specifically, given
the $1.79 price of the call option, the price of the corresponding put option is
X 60
P0 = C0 − S0 + = 1.79 − 50 + = $8.93,
T 1.05
(1 + r )
the same as in direct calculation of the put option price f ound by using
Equation 5.24.
Two-Period Binomial Pricing Model

A slightly more involved extension of the single-period option-pricing frame-
work allows f or two periods in which the security price can move. In this
section, we examine that binomial pricing model for two periods and then, in
a subsequent section, extend the hedging logic into multiperiod and “continu-
ous time” models.
Figure 5.3 illustrates a split in the time to expiration into two equal
subperiods, in each of which the stock price may change. If the stock has
gone up in the first subperiod, it can then go up again to a price of Suu or
down to a price of Sud. If the security has gone down in the first subperiod,
it can then go up to a price of Sdu or down to a price of Sdd. For simplicity,
we assume that the up/down path leads to the same price as the down/
up path, Sud = Sdu, although the analysis doesn’t require this assumption.
Similarly, if the security price first goes up, the call option has a value of
Cu, and if it goes down, the call option is worth Cd. In the second subperiod
encompassing the option expiration date, the security price can move up or
down again, and the value of the option at that point will be defined by its
exercise value.

Figure 5.3. Two-Period Binomial Pricing Model
Suu
Su
Sud = Sdu
S0
Sd
Sdd
Cuu
Cu
Cud = Cdu
C0
Cd
Cdd
Although this two-period model is more complex than the one-period

model, the arbitrage logic is similar. Suppose the security price has gone up,
so the security price is at the point Su in Figure 5.3. With one period lef t,
the value of the call option, Cu, can be determined by constructing a riskless
hedge on the two possible prices with one period to go, Cuu and Cud. As we
have shown, f or the call option, the one-period hedge gives a f ully deter-
mined price that must hold to avoid arbitrage possibilities.
Now, suppose the security price has gone down in the first period to Sd.
Again, the value of the call option at this point, Cd, can be determined by
constructing a riskless hedge on the two possible prices with one period to
go, Cdu and Cdd. Knowing the two possible option values at the intermediate
point, Cu and Cd, the arbitrageur can work backwards to determine the cur-
rent value of the call option, C0.
The key concept is that multiperiod models are solved by working
backward from the possible terminal option values. Specifically, the option
value at the left side of each branch of the binomial tree is established by
using the value of the stock price for that particular path to determine the
value of the option at expiration. Hedging logic is then used to establish

the intermediate option prices and used again to establish the initial
option price.
A common practice in constructing the price path “tree” for the stock (top
half of Figure 5.3) is to assume the same proportions in price movement over
time. For example, if the stock price goes up by 10% or down by 5% in the
first period, then the price is again assumed to go up by 10% or down by 5%
in the second period. As long as this convention is followed, the value of the
risk-neutral probability variable, q, remains constant over time and across dif-
ferent price paths. In that case, formulas for the intermediate-date call option
values can be substituted into the formula for the current call value, giving a
compact solution of
qCu + (1 − q )Cd
C0 =
(1 + r )T / 2
(5.25)
q 2Cuu + 2q (1 − q )Cud + (1 − q )2 Cdd
= .
(1 + r )T
Notice that the intermediate-term call option values in Equation
5.25 are discounted f or only half the total time to option expiration, T/2.
However, the intermediate-term option values, Cu and Cd, are, in turn, based
on discounting the final call value for the remaining time to option expira-
tion, T/2, so f ull-period discounting shows up in the denominator of the
last term. Also, be aware that although the risk-neutral probability variable,
q, remains constant over time, the hedge ratio, h, does not. For example, if
the stock price goes up in the first period, arbitrageurs will generally need
to increase the hedge ratio because the call option will become more sen-
sitive to subsequent stock price changes. (In Black–Scholes option-pricing
terminology, this condition is known as a higher delta.) If the stock price goes
down in the first period, arbitrageurs may need to decrease the hedge ratio.
The process of changing the amount of the underlying security owned over
time to maintain a riskless position is known as dynamic hedging, and it is a
common practice by those who are trying to exploit arbitrage opportunities
in the option markets.
For a numerical example of the two-period binomial process, suppose,
again, that the stock price initially starts at $50 but can take on three possible
prices at the expiration of the option. Specifically, for each of the two subpe-
riods, the price can increase by 20% or decrease by 10%. If the price goes up
20% to $60 in the first subperiod, then it might go up by another 20% to $72
in the second period or go down by 10% to $54. If the stock price goes down
10% in the first subperiod to $45, then it might subsequently go up 20% to
$54 or down by 10% to $40.50. For these prices, the final payoffs to a call
option with a strike price of $60 are

Cuu = max( Suu − X , 0) = max(72 − 60, 0) = 12;

Cud = max( Sud − X , 0) = max(54 − 600, 0) = 0;
Cdd = max( Sdd − X , 0) = max(40.50 − 60, 0) = 0.
Thus, the call option expires in the money for only one of the three possible
expiration-date values of the stock.
Suppose, as before, that the total time to option expiration is one year, so
each of the two subperiods is six months. For numerical simplicity, we will set
the six-month risk-free interest rate at 2%, so the effective annual rate is (1.0 +
0.02)2 – 1 = 4.04%. With these parameter values, the risk-neutral probability
of an up move in the security price is
1.02 − 0.9
q =
1.2 − 0.9
= 0.4
for each subperiod. The arbitrage-free price of the call option if the stock goes
up in the first subperiod is
(0.4) 12 + (1 − 0.4) 0
Cu =
1 + 0.02
= $4.71,
and the call price if the stock goes down in the first subperiod is
(0.4) 0 + (1 − 0.4) 0
Cd =
1 + 0.02
= $0.
Note that the dynamic hedge ratio if the stock goes up in the first period will be
(12 – 0)/(72 – 54) = 0.667 (i.e., two-thirds) whereas the dynamic hedge ratio if
the stock goes down will be (0 – 0)/(54 – 40.50) = 0.00. If the stock goes down
in the first period, no hedge is needed because the call option value does not
vary between the two subsequently possible stock prices. By working backward,
we can now determine the current arbitrage-free price of the call option as
(0.40)4.71 + (1 − 0.40)0
C0 =
1 + 0.02
= $1.85,
which can also be verified by a more direct hedging calculation using the
initial call option hedge ratio of (4.71 – 0)/(60 – 45) = 0.314.
The final payoffs to a put option with a strike price of $60 are
Puu = max( X − Suu , 0) = max(60 − 72, 0) = 0;
Pud = max( X − Sud , 0) = max(60 − 54,, 0) = 6;
Pdd = max( X − Sdd , 0) = max(60 − 40.50, 0) = 19.50.

In other words, the put option expires out of the money for the highest pos-
sible stock price but in the money for the other two values of the stock. The
arbitrage-free price of the put option if the stock goes up in the first subperiod is
(0.40) 0 + (1 − 0.40) 6
Pu = = $3.53,
1 + 0.02
and the put price if the stock goes down in the first subperiod is
(0.40) 6 + (1 − 0.40) 19.50
Pd = = $13.82.
1 + 0.02
Using the single compact version of the formula in Equation 5.25, we find the
current value of the put option to be
qPu + (1 − q ) Pd (0.40)3.53 + (0.60)13.82

P0 = = = $9.52.
T /2 1 + 0.02
(1 + r )
The same put price is derived from the expanded version of Equation 5.25,
q 2 Puu + 2q (1 − q ) Pud + (1 − q )2 Pdd

P0 =
(1 + r )T
(0.40)2 0 + 2(0.40)(0.60)6
6 + (0.60)219.50
= = $9.52.
(1 + 0.02)2
The dynamic hedge ratio for the put option if the stock goes up in the
first period will be (6 – 0)/(72 – 54) = 0.33 (one-third), whereas the put hedge
ratio will be (19.50 – 6)/(54 – 40.50) = 1.00 if the stock price goes down. The
hedge ratio of 1.0 is needed because after the initial decline in the stock price,
the spread of subsequent possible put option values equals the spread of pos-
sible stock prices. As the reader will observe in the more sophisticated Black–
Scholes f ormula, the European put option hedge ratio is always 1.0 minus
the European call option hedge ratio. For example, the initial hedge ratio for
the put option is (13.82 – 3.52)/(60 – 45) = 0.686, or 1.0 minus the previously
calculated call option hedge of 0.314.
Because they are European options, the call and put prices we just cal-
culated are consistent with put–call parity. Specifically, the put price can be
calculated directly from the call price by
X 60
P0 = C0 − S0 + = 1.85 − 50 + = $9.52.
T
(1 + r ) (1 + 0.02)2
The price of the put option would be somewhat higher if early exercise
were allowed. As we calculated, the riskless hedge value for the put option

if the stock price goes down to $45 in the first subperiod is $13.82, but
this amount is below the exercise value at that point of 60 – 45 = $15.00.
If the options are American, then arbitrageurs will anticipate the possibil-
ity of early exercise, so the initial price of the put option will be based on
the intermediate-term put values of $3.53 and $15.00, not $3.53 and $13.82.
Thus, the initial price of an American put option from the compact version of
Equation 5.25 will be
qPu + (1 − q ) Pd (0.40)3.53 + (0.60)15.00
P0 = = = $10.21,
T /2 1 + 0.02
(1 + r )
which is 69 cents higher than the European put price of $9.52.

The corresponding American call option price would not be higher in this
case because we have assumed that the underlying stock does not pay a divi-
dend, so early exercise of the call option would never be desirable.
Multiperiod Binomial and Black–Scholes Models

The process of dividing the time until option expiration into smaller and
smaller portions can be continued for three, four, and in general, N subperi-
ods. Although more complex branching processing can be modeled, a com-
mon practice is to assume that branches recombine, as in the assumption that
Sud = Sdu in the two-period tree of Figure 5.3. In that case, the number of
terminal stock prices will be the number of subperiods plus 1.
For example, Figure 5.4 shows the price tree for a three-period model and
four terminal stock prices. To arrive at increasingly more accurate arbitrage-
free prices for the option at time zero, the arbitrageur must take care to ensure
that the jump sizes and present value discounting in the branching process are
consistent with the increasingly shorter subperiods. For a time-to-expiration
Figure 5.4. Multiperiod Binomial Model
S0

volatility parameter σ and price trend µ, the initial up and down jumps can be
calculated by
Su = S 0 e µ / T + σ T / N
and (5.26)
S d = S 0 eµ / T − σ T / N ,
where e( ) indicates exponentiation (e being the natural number 2.17828).
The numerical choice for the price trend parameter, µ, can be based on
an expected return f or the stock or, as is more common, the risk-f ree rate,
consistent with the notion of risk-neutral pricing. In the limit, as N increases
to a large number, this parameter choice will not affect the final calculation of
the current option price.
As the number of subperiods increases, more and more terms are added
to the compact formulas for the current option prices discussed in the prior
section. The probabilities of each possible outcome combine according to the
binomial distribution—for example, q3 for the possibility of three consecutive
moves up or q2(1 – q) for two moves up and then one move down. In the limit,
the binomial process converges to the well-known Black–Scholes model for a
European option with no cash distributions:
C0 = S0 N (d1 ) − X e− rT N (d 2 ), (5.27)
where
ln( S0 / X ) + (r + σ2 / 2)T
d1 =
σ T
and (5.28)
ln( S0 / X ) + (r − σ2 / 2)T
d2 = .
σ T
The Black–Scholes model in Equations 5.27 and 5.28 uses a number of
f unctions associated with continuous-time financial mathematics. The f unc-
tion ln( ) is the natural logarithm, called LN( ) in Excel. The function e( ) is
exponentiation, called EXP( ) in Excel. The f unction N( ) is the cumula-
tive standard normal distribution, called NORM.S.DIST( ) in Excel with
the cumulative flag set to “true.” In continuous-time mathematics, present
values are calculated by the term e − rT instead of the more familiar 1/(1 + R)T
formulation used in discrete time. The parameter T is still the time to option
expiration, measured in years, but the risk-free rate, r, is a continuously com-
pounded return. Discrete annual rates can be converted to a continuous-time
rate by using the relationship

r = ln(1 + R ). (5.29)
For example, if the discrete annual risk-free rate is 5.00%, then the continu-
ously compounded rate is ln(1 + 0.05) = 4.879%. For example, a present value
of X = 100 discounted for three months (0.25 years) can be calculated either
in discrete time as 100/(1 + 0.05)0.25 = $98.79 or in continuous time as 100 ×
e –0.04879(0.25) = $98.79.
With its assumption of continuous time, the Black–Scholes model has
some recognizable similarities to the multiperiod binomial model. Both
involve probabilities, and both include a present value calculation at the
risk-f ree rate over the time to expiration of the option. The inputs to the
Black–Scholes model include the current stock price, S0; the option exercise
price, X; the time to option expiration, T ; and the continuously compounded
risk-free rate, r. The only new parameter is a measure of annualized volatility
in the underlying security price, σ, which conceptually replaces the spread of
possible stock prices in the binomial model.
The Black–Scholes price for a European put option can be derived from
the European call price and the put–call parity relationship with continu-
ous compounding:
p0 = c0 − S0 + Xe− rT
(5.30)
= − S0 [1 − N (d1 ) ] + Xe− rT [1 − N (d 2 ) ] ,
where d1 and d 2 are defined as in Equations 5.28.
We can illustrate Black–Scholes model calculations with some simple
parameters. Suppose the underlying stock price is S0 = $100 and we are
pricing at-the-money European-style options with a strike price of X =
$100. The options have one month to expiration, so T = 1/12 (approximately
0.8333), and the continuously compounded annual risk-free rate is 2%. We
will use an underlying security volatility estimate of 40%. Using Equations
5.28 and the standard cumulative normal distribution function, we have
 ln(100 /100) + (0.02 + 0.402 / 2)(0.0833) 
N (d1 ) = N  
 0.40 0.0833 
= N ( 0.07217 )
= 0.529
and
 ln(100 /100) + (0.02 − 0.402 / 2)(0.0833) 
N (d 2 ) = N  
 0.40 0.0833 
= N ( −0.04330 )
= 0.483.

Inserting these values in Equation 5.27 gives us the current price of the call
option as
C0 = 100(0.529) − 100 e−0.02(0.0833) (0.483)
= $4.68.
Using Equation 5.30, we find the corresponding put option to be
P0 = − 100 (1 − 0.529) + 100 e−0.02(0.0833) (1 − 0.483)
= $4.52.
With the Black–Scholes formulas, we can easily see how the call and put
prices respond to changes in the various input parameters. The two curves in
Figure 5.5 plot the call and put prices for changes in the underlying stock price
from $80 to $100, with the other parameters held constant. As the security price
increases, the call price increases from almost zero to about $20 but the put price
decreases from about $20 to almost zero. The prices of the two options are equal
when the stock hits the present value of the strike price, just below $100.
Figure 5.5. Relationship of Option Prices to the Security Price
Option Price
25
20
Put Price Call Price
15
10
0
80 85 90 95 100 105 110 115 120
Figure 5.6 plots how the option prices change with time to expiration
with the stock price held at $100. For these two at-the-money options, the
entire option price is time value. For at-the-money options, call options
have a slightly higher price than put options because of the positive risk-
less interest rate. But as the options near expiration, the time value decays
toward zero.
Figure 5.7 shows how the option prices change for different volatility param-
eters. As previously mentioned, the at-the-money call price is slightly higher than

Figure 5.6. Relationship of Option Prices to Time to Expiration
Option Price
20
15 Call Price
Put Price
10
0
0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0
Time to Expiration (years)
Figure 5.7. Relationship of Option Prices to Volatility
Option Price
10
6 Call Price
4 Put Price
0
0 10 20 30 40 50 60 70 80
Underlying Security Volatility (%)
the put price, but both option prices increase in value almost linearly with vola-
tility. Option prices increase with volatility because the range of possible stock
prices at expiration grows; thus, the potential payoffs to each option grow.
Figure 5.8 shows how the call and put option prices respond to changes
in the risk-f ree interest rate. The price of the call option increases with an
increase in interest rates, and the price of the put option decreases. These

Figure 5.8. Relationship of Option Prices to Interest Rates
Option Price
5.0
4.8 Call Price
4.6
4.4 Put Price
4.2
4.0
0 1 2 3 4 5 6 7 8
Interest Rate (%)
effects are consistent with the opportunity cost of early exercise implied in the
time value of the put and call option prices discussed earlier.
Of all the inputs to the Black–Scholes option price, the volatility estimate
is the most subjective. The price of the underlying stock is quoted by the market
daily (in fact, continuously), and the strike price and option expiration dates are
specified up front and do not change. Risk-free borrowing and lending rates for
arbitrageurs are generally close to LIBOR or some other market-based short-term
interest rate. Analysts can use historical returns to calculate what the volatility has
been in the past, although these calculations need to be adjusted for the frequency
of returns to arrive at an annualized number. If daily returns are used, the variance
(standard deviation squared) is typically multiplied by 250, the number of trading
days per year. If monthly returns are used, the variance is multiplied by 12.
Alternatively, an analyst can use all the other inputs to the model to infer
a volatility estimate from the observed market prices for the option. This esti-
mate of volatility is called the option’s implied volatility. The volatility implied by
the current option price can then be compared with historical volatility. Implied
volatility higher than historical volatility may indicate that the option is expen-
sive relative to historical measures; lower implied volatility may indicate that
the option is cheap. Table 5.1 gives the volatility implied by various call option
prices, with the other previously discussed input parameters, and using the Solver
functionality within Excel. The volatility estimate of 40% used throughout this
section results in a call option price of $4.68, so the implied volatilities for the
$4.00 and $5.00 quotes are, respectively, lower and higher than this estimate.

Table 5.1. Implied Volatilities from

the Black–Scholes Model
Call Price Quote Implied Volatility
$1.00 7.95%
2.00 16.65
3.00 25.35
4.00 35.04
5.00 42.75
6.00 51.46
7.00 60.18
8.00 68.91
9.00 77.65
A simple analytic approximation of the implied volatility can be cal-

culated f or the average price of a put–call pair that is close to the money.
Specifically, Brenner and Subrahmanyam (1988) show that the implied vola-
tility resulting from a Black–Scholes model can be approximated by
C +P 2π
σ= 0 0 . (5.31)
2 S0 T
For example, the at-the-money $100-strike-price options with exactly one
month (1/12 year) to expiration were calculated previously as C0 = $4.68 and P0 =
$4.52. Putting these values into the analytic approximation, Equation 5.31, give
4.68 + 4.52 2π
σ=
2(100) 1 / 12
= 39.94%,
which is quite close to the actual volatility of 40.00% used by the Black–
Scholes formula to calculate the option prices earlier in this section. The put
and call options used for the approximation need to have the same strike price
and maturity, and the best approximation of implied volatility is based on
put–call pairs that are close to being at the money.
Black–Scholes Option Price Assumptions

Like any formula, the Black–Scholes model depends on a number of simplify-
ing assumptions. First and foremost, the Black–Scholes formula is a continuous-
time extension of the binomial model with no early exercise. Thus, the basic
f ormula strictly applies only to European-style options. Also, the f ormula is
based on the assumption that the underlying security return is lognormally dis-
tributed and that the volatility of the underlying security is constant over time.
In essence, the model does not allow for instantaneous jumps in the security

price. Over a very short period of time, the security can move a little but not a
large amount. The original model also assumes no dividends or cash payments
on the underlying security and assumes constant interest rates.
Researchers have tried to develop models to relax most of these assumptions,
and many of today’s models are variations of the original 1972 Black–Scholes
f ormula. Interestingly, the mathematically more sophisticated Black–Scholes
f ormula was developed bef ore simple binomial pricing methods were devel-
oped. Only later did researchers show that the binomial model converges to the
Black–Scholes model under consistently applied up and down price movements
in the underlying security (see Sharpe 1985; Cox, Ross, and Rubinstein 1979).
The easiest assumption to relax in the basic Black–Scholes model is the
requirement of no cash distributions in the underlying security. For known
discrete dividends, the current stock price needs to be adjusted by the pres-
ent value of the dividends before being used in the Black–Scholes model. For
example, suppose the current stock price is S0 with a cash dividend, D, paid at
time t prior to the option expiration at time T. Using continuous-time math-
ematics, the dividend-adjusted stock price is
S0* = S0 − De− rt , (5.32)
and it can be substituted for the input parameter S0 wherever it occurs in the basic
Black–Scholes formula in Equations 5.27 and 5.28. The incorporation of the divi-
dend payment slightly reduces the price of a call option and increases the price of
a put option, similar to the effect of a small decrease in the actual stock price.
Another approach to adjusting the stock price is to assume that the dividend
is paid continuously at a known yield (see Merton 1973a). This assumption is
usef ul because it can approximate the impact of dividends on an equity index
option because the many different stocks in an index pay dividends at different
times. The adjustment is as follows: If d represents the aggregate annual dividend
yield, the adjusted stock price for an index option with expiration date T is
S0* = S0 e− dT . (5.33)
Options on foreign exchange rates can also be put into this f ramework.
In the case of these options, the riskless asset denominated in the f oreign
currency pays continuous interest at rate rf , similar to a continuous dividend
yield. That is, if S0 represents the underlying exchange rate (rather than, say,
the price of a stock), the modification involves substituting
−rf T (5.34)
S0* = S0 e
for each occurrence of S0 in the standard Black–Scholes formula in Equations
5.27 and 5.28.
The dividend and f oreign exchange adjustments presented here assume
that the options cannot be exercised early, but more complicated variations of

the Black–Scholes model for American-style options do allow for early exer-
cise. Generally, American-style options are priced by the use of multiperiod
binomial pricing techniques, which can be programmed to model complex
early-exercise possibilities.
The following summarizes the variations on the Black–Scholes formulas
we have discussed so far:
Discrete cash payout: S0* = S0 − De− rt where D = payout at time t

where d is the annual
Continuous cash payout: S0* = S0 e− dT continuous rate
where r f is the annual
−rf T
Currency option: S0* = S0 e foreign interest rate
Relaxing some of the other assumptions of the Black–Scholes model is

more difficult than modif ying it for cash distributions. Some attempts have
been made to develop models in which the underlying security price is not
lognormally distributed. For example, Bookstaber and McDonald (1985)
developed models with more general probability distributions, of which the
lognormal distribution is a special case. Relaxing the assumptions of constant
variance and interest rates is even more difficult. Specialized models for fixed-
income options have been developed, however, by relaxing the assumption of
constant interest rates (see Dattatreya and Fabozzi 1989; Black, Derman, and
Toy 1990).
Options on Futures
An option on a futures contract differs from a direct option on the underlying
security in that the buyer of the futures option establishes a position in a futures
contract upon exercise instead of in the underlying security. In many respects,
an investor can think of the f utures as simply another underlying security to
which the option is tied. As with regular options, buyers of f utures options
must pay a price for the option, sellers receive the option price, and sellers are
generally required to post margin. After exercise of the option, both the long
and short futures positions are required to post margin and mark to market, as
with any other investor in f utures. Many f utures options expire on the same
date as the f utures contract itself, although the U.S. Treasury bond and note
f utures options are an exception. Specifically, options on T-bond and T-note
futures expire a month before the futures contract, so the investor can take full
advantage of the delivery window for T-bond and T-note futures contracts.
The put–call parity relationship for European futures options is similar to
that for cash options. A riskless payoff at time T can be constructed by buying

f utures, selling a f utures call option, and buying a f utures put option. The
contingency table follows.
FT < X FT > X
Purchase futures F T – F0 F T – F0
Sell call 0 – (F T – X)
Purchase put X – FT 0
Total payoff X – F0 X – F0
Because the payoff from this strategy is riskless, the present value of this pay-
off must equal the net amount of funds invested,
X − F0
p0 − c0 = , (5.35)
(1 + r )T
which is somewhat similar to the put–call parity relationship for cash options.
Indeed, if the futures contract is priced like a forward contract, F0 = S0 (l + r)T,
the price of a European call is
X
c0 = p0 + S0 − , (5.36)
(1 + r )T
which is simply the cash put–call parity relationship. If the option on a futures
contract cannot be exercised early and the option and f utures expire at the
same time, the European futures option is no different from a European cash
option. This characteristic results from the fact that, at expiration, the futures
price and cash price will be equal. The fact that the futures price and security
price are different before expiration does not matter if the futures option can-
not be exercised early.
Fischer Black (1976) developed a variation of the Black–Scholes model to
apply to a European futures option:
c0 = F0 e− rT N (d1 ) − Xe− rT N (d 2 ), (5.37)
where F0 is the current futures price and
ln( F0 / X ) + σ2T / 2
d1 =
σ T
and (5.38)
ln( F0 / X ) − σ2T / 2
d2 = .
σ T
Notice that the Black model for futures options in Equation 5.37 is similar to the
more common Black–Scholes model in Equation 5.27, with F0 replacing S0, and

the formulas for d1 and d2 in Equation 5.38 have one fewer term than in Equation
5.27. Indeed, the Black model simply substitutes the present value of the futures
price (using continuous compounding) for the cash price by using the formula
S0* = F0 e− rT . (5.39)
For European options, the value for a f utures put option can be derived
from the put–call parity relationship (using continuous compounding) together
with the Black model for the value of the futures call option:
p0 = c0 + ( X − F0 ) e− rT . (5.40)
Substitution of the value f or the f utures call option gives the f utures put
option price as
p0 = − F0 e− rT [1 − N (d1 ) ] + Xe− rT [1 − N (d 2 ) ]. (5.41)
One of the major differences between f utures options and regular cash
options occurs when the options are American and can thus be exercised early.
Although exercising an American call option early is not advisable unless there
is a large cash distribution on the underlying security, exercising the American
call option on a futures contract may be desirable if the payoff from early exer-
cise is greater than the value of the corresponding option without early exercise:
F0 − X > c0 . (5.42)
Substituting for the value of the call option using put–call parity for European
futures options gives the equivalent condition as
p0 < ( F0 − X )(1 − e− rT ), (5.43)
which can occur if the call option is far enough in the money to result in a
small put price.
Exercising a futures put option early is desirable if the payoff from early
exercise is greater than the value of the option:
X − F0 > p0 . (5.44)
Substituting for the value of the put option using put–call parity for European
futures options gives the equivalent condition as
c0 < ( X − F0 )(1 − e− rT ), (5.45)
which can occur if the put option is far enough in the money to result in a
small call price. The logic is that if the put or call options are deep enough
in the money, their time value components are small and the option value is
dominated by intrinsic value. The interest available to be earned on the intrin-
sic value makes early exercise of the futures options worthwhile because the
investor will lose the time value of the option but gain an even greater value
from being able to invest in the intrinsic value.

6. Option Contracts: Hedging
Relationships
In this chapter, we describe some of the techniques used to monitor option

positions and manage option-related exposures. The first section deals with
how an option price moves as its parameters change, and the second section
addresses how to use these measures to help control the risk in a portfolio.
In the final section, we explore some alternative ways to create option-like
effects in a portfolio.
Sensitivity Measures
Option analysts use a series of Greek letters to describe how a call option’s
price changes as its parameters change, as shown in Table 6.1. The first
and most important “greek” is delta, ∆, which describes the change in the
option price resulting from a change in the price of the underlying security.
The delta of an option is also known as the hedge ratio because it specifies
the number of shares in the underlying security needed to offset a change
in option value resulting f rom changes in the underlying security’s price.
Mathematically, delta is the partial derivative of the option price with
respect to a change in S0, the underlying security price. Another greek,
gamma, γ, describes the change in option price f or a change in delta—in
other words, the second partial derivative of the option price with respect to
a change in the security price.
Table 6.1 Call Option Sensitivity Measures

Name Sensitivity to Notation
∂C0
Delta Security price ∆c =
∂S0
Gamma Delta
∂ 2C0
γc =
∂S02
Theta Time to expiration

∂C0
θc = −
∂T
Rho Interest rate

∂C0
ρc =
∂r
Vega Volatility
∂C0
νc =
∂σ

A third greek is theta, θ, the change in option price because of the passage
of time. The definition of theta includes a negative sign because option prices,
both calls and puts, decrease as they get closer to expiration. In other words,
as the option nears expiration, the time value component approaches zero,
so the option price is either the exercise value (if the option expires in the
money) or zero (if the option expires out of the money). A fourth greek is rho,
ρ, which measures the sensitivity of the option price to a change in interest
rates. The final measure of option price sensitivity is vega, which is not actu-
ally a letter in the Greek alphabet, so the notation ν (Greek letter nu) is used.
Vega measures the sensitivity of the option price to changes in the volatility of
the underlying security. Table 6.2 gives the formulas for each of the five sen-
sitivity measures in terms of the Black–Scholes valuation model. Notice that
the formulas for gamma and vega are the same for both put and call options.
Table 6.2 Option Sensitivity Formulas in Terms of the Black–Scholes Model

Name (measure) Call Option Put Option
Delta (security price) ∆ c = N (d1 ) ∆ p = ∆c −1
n(d1 )
Gamma (delta) γc =
S0σ T γ p = γc
S0 σ n(d1 )
Theta (time to θc = − − r X e− rT N (d 2 ) θ p = θc + r X e− rT
expiration) 2 T
ρc = X T e− rT N (d 2 ) ρ p = ρc − X T e− rT
Rho (interest rate)
νc = S0 T n(d1 ) ν p = νc
Vega (volatility)
−d 2 / 2
Note: The term n(d) is the standard normal probability density function, n( d ) = e / 2π ,
d
and N(d) is the standard normal cumulative distribution f unction, N ( d ) = ∫−∞
n(d ).
Strictly speaking, these formulas apply to European options, not to American options, which
allow for early exercise.
Table 6.3 provides example values for each of the sensitivity measures.
The numerical examples in Table 6.3 are for options with an exercise price
of $100 that are currently at the money (i.e., the underlying security price
is at $100) with one month to expiration, where the annual continuously
compounded interest rate is 2% and the underlying security volatility is

Option Contracts: Hedging Relationships
Table 6.3 Example Values for Call and Put Option

Sensitivity Measures
Name Call Put
Delta (per 1.00) 0.529 –0.471
Gamma (per delta) 0.034 0.034
Theta (per day) –0.073 –0.067
Rho (per 1%) 0.040 –0.043
Vega (per 1%) 0.115 0.115

Note: The assumptions are S0 = $100, X = $100, T = 1/12 (30.4 days),
r = 2.00%, and  = 40.0%.
40%. For example, the call option delta is 0.529, meaning that if the under-
lying security price rises by $1.00, the price of the call option will increase
by 52.9 cents.
Delta. The delta on a put option is closely related to the delta on a call
option, as shown by the put–call parity relationship in Equation 5.30. Taking
the derivative of both sides of Equation 5.30 with respect to S0 gives
∆ P = ∆C −1, (6.1)
as shown at the top of the last column in Table 6.2. Note that the delta of a put
option is always equal to the delta of the corresponding call option minus 1.
Deltas on call options range from 0, for deeply out-of-the-money options,
to 1, for deeply in-the-money options. Thus, the delta of the corresponding
put option will be a negative value between –1 and 0.
Option deltas can be used to calculate beta (sensitivity to the market)
in equity markets and duration (sensitivity to interest rates) in fixed-income
markets. In equity markets, beta is a common measure of the sensitivity of
an individual stock price to changes in the general market (i.e., to changes
in a market index or benchmark). Specifically, beta measures the percentage
change in stock price for any percentage change in a market index. The mar-
ket beta of a call option is equal to the beta of the stock multiplied by the ratio
of the prices of the stock and call option, S0/C0, multiplied by the delta of the
call option:

S 
βc = β S  0  ∆c . (6.2)
 C0 
Similarly, modified duration in fixed-income markets measures the percent-
age change in the bond price for a change in yield. The modified duration of a
call option is equal to the modified duration of the underlying bond, DB* ,
multiplied by the ratio of the bond and call option prices, B0/C0, multiplied by
the call option delta:
B 
Dc* = DB*  0  ∆C . (6.3)
 C0 
The equity market beta and fixed-income duration for put options have the
same form and can be found by substituting the delta and price of the put
option for the delta and price of the call option in Equations 6.2 and 6.3.
Figure 6.1 plots the Black–Scholes model call and put option deltas f or
underlying security prices from $80 to $120 for the sample numerical values in
Table 6.3. As shown in Figure 6.1, when the call option is deeply out of the
money, the delta is close to 0, and when the call option is deeply in the money,
the delta approaches 1. The delta of the call option is always positive, meaning
that the option price always increases with increases in the underlying security
price. The delta of the put option is always negative, meaning that the option
price always decreases with increases in the underlying security price. Note the
constant gap between the delta of the call and the delta of the put, which occurs
because the delta of the put option is equal to the delta of the call option minus 1.
Figure 6.1. Relationship of Delta to Underlying Security Price
Delta
1.0
0.8
0.6 Call Delta
0.4
0.2
0
–0.2
–0.4
Put Delta
–0.6
–0.8
–1.0
80 85 90 95 100 105 110 115 120
Underlying Security Price ($)

Delta is also sensitive to the time to expiration of the option. Figure 6.2
shows how the delta plots change for a longer-maturity option—that is, three
months to expiration instead of only one month. The delta curve tends to flat-
ten out with a longer-maturity option. In other words, the sensitivity of the
option price to changes in the underlying security price is more stable for a
longer-maturity option.
Figure 6.2. Relationship of Delta to Underlying Security Price for Three

Months vs. One Month to Expiration
Delta
1.0
0.8
0.6 Call Delta
0.4
0.2
0
–0.2
–0.4 Put Delta
–0.6
–0.8
–1.0
80 85 90 95 100 105 110 115 120
Call Delta (one month) Put Delta (one month)

Call Delta (three months) Put Delta (three months)
Gamma. Because delta is probably the most important sensitivity mea-

sure of all the greeks, analysts also measure changes in delta in response to
changes in the underlying security price. So, gamma is a second derivative
with respect to security price, somewhat like the use of convexity in addition
to duration by fixed-income analysts.
Figure 6.3 plots the gamma of the put–call pair (both have the same
gamma) used in the previous figures for various levels of the underlying security
price. Gamma is highest (change of delta is greatest) when options are near the
money. When options are way out of the money or way in the money, the delta
plot in Figure 6.1 is not as steep, so gamma is smaller. At its peak, the gamma
plot in Figure 6.3 indicates that a $1 move in the underlying security price will
increase the delta by about 0.035. For example, if the call option delta happened
to be 0.500, a $1 increase in the security price would increase the delta to 0.535.

Figure 6.3. Relationship of Call and Put Gamma to Underlying Security

Price
Gamma
0.05
0.04
0.03
0.02
0.01
0
80 85 90 95 100 105 110 115 120
Like delta, gamma is also sensitive to the time to expiration of the option.
Figure 6.4 shows that the gamma curve flattens out f or longer-maturity
Figure 6.4. Relationship of Gamma to Underlying Security Price for

Three Months vs. One Month to Expiration
Gamma
0.05
0.04
One Month
0.03
0.02
Three Months
0.01
0
80 85 90 95 100 105 110 115 120

options, meaning that the change in delta is less variable for any change in
security price for longer-maturity options.
Theta. Figure 6.5 plots the sensitivity of option prices to time to expira-
tion, where theta is measured as price change per day instead of year. Theta
is, by definition, negative f or both the call and the put options, indicating
that options are “wasting” assets in that, with the other parameters held con-
stant, their values go down over time. Note in Figure 6.5 that the call option
is slightly more sensitive to time decay than is the put option for any given
security price. For example, at its extreme point, when the options are near
the money, the call option will lose a little more than $0.07 a day in value
whereas the put option will lose a little less than $0.07 a day.
Figure 6.5. Relationship of (Daily) Theta to Underlying Security Price
Theta
0.02
0.01
0
–0.01
–0.02
Put Theta
–0.03
–0.04
–0.05
–0.06 Call Theta
–0.07
–0.08
–0.09
80 85 90 95 100 105 110 115 120
Time decay is also sensitive to the expiration date of the option, as shown in
Figure 6.6 for the call option. Specifically, time decay is more constant across
the range of moneyness with an option that is further away from expiration.
Rho. Figure 6.7 plots rho, which measures the sensitivity of the call and
put option prices to changes in interest rates. The rho for call options is always
positive; that is, the call option price increases f or increases in the interest
rate. The rho for put options is always negative. The right to buy later at some
fixed price is worth more when interest rates are higher, and the right to sell
later at a fixed price is worth less. When the call option is deeply out of the

Figure 6.6. Relationship of (Daily) Theta to Underlying Security Price

for Three Months vs. One Month to Expiration
Theta
0.02
0.01
0
–0.01
–0.02
–0.03
Three Months
–0.04
–0.05
–0.06
–0.07 One Month
–0.08
–0.09
80 85 90 95 100 105 110 115 120
money, it has little sensitivity to interest rates, but sensitivity increases when
the call option is in the money. The numerical value of rho indicates that for
at-the-money call options with an underlying security price of $100, a 1 per-
centage point increase in the interest rate would increase the call option price
Figure 6.7. Relationship of Rho to Underlying Security Price
Rho
0.10
0.08
0.06
0.04 Call Rho
0.02
0
–0.02
–0.04
Put Rho
–0.06
–0.08
–0.10
80 85 90 95 100 105 110 115 120

by about 4 cents. The put option is also more sensitive to interest rate changes
when it is in the money than when it is out of the money, but as stated, the
rho for a put option is negative.
Interest rate sensitivity is also a f unction of the time to expiration, as
shown in Figure 6.8 for the call option. Intuitively, the values of longer-term
options are more sensitive to interest rate changes than are near-term options.
Figure 6.8. Relationship of Rho to Underlying Security Price for Three

Months vs. One Month to Expiration
Rho
0.25
0.20
0.15 Three Months
0.10
One Month
0.05
0
80 85 90 95 100 105 110 115 120
Vega. Figure 6.9 plots the sensitivity of the option price to the volatil-
ity of the underlying security, or vega, which is the same value for both the
call and put options. The figure shows that options are the most sensitive
to changes in the volatility estimate when they are close to being at the
money and in fact show little sensitivity to volatility when they are either
far in or out of the money. For example, when a call option is deeply out of
the money, the security price must move a lot before the call has any pos-
sibility of positive exercise value. Similarly, when the call option is deeply
in the money, the underlying security price has to move a lot before the call
would expire worthless. But when the underlying security price is close to
the strike price, and the option is thus at the money, the volatility estimate
is quite important and changes have a bigger impact on the value of the
option because small movements in price will determine whether the option
is in the money or not.

Figure 6.9. Relationship of Call and Put Vega to Underlying Security

Price
Vega
0.25
0.20
0.15
0.10
0.05
0
80 85 90 95 100 105 110 115 120
Vega is also sensitive to the maturity of the option, as shown in Figure

6.10. Long-maturity options are much more sensitive to changes in the
Figure 6.10. Relationship of Call and Put Vega to Underlying Security

Price for Three Months vs. One Month to Expiration
Vega
0.25
0.20 Three Months
0.15
One Month
0.10
0.05
0
80 85 90 95 100 105 110 115 120

volatility estimate than are shorter-maturity options. For example, when at

the money, a three-month option would increase in price by about 20 cents
f or a 1 percentage point increase in volatility, whereas a one-month option
would increase by only about 11 cents.
Risk Control Using Sensitivity Measures

The measures we have discussed describe the sensitivity of options to several
parameters. An experienced investor would intuitively know the direction
and approximate amount of risk associated with changes in market values,
such as the underlying security price and volatility, but the greeks help quan-
tify that risk and facilitate precise hedging strategies.
In terms of the size of the impact on option prices, the most crucial
sensitivity measure is delta because other parameters tend to change more
slowly than the underlying security price. Because delta is such a critical risk
measure, gamma also plays an important role in measuring how rapidly delta
might change as the security price changes. After delta and gamma, vega is
perhaps the next most important sensitivity measure because the expected
volatility of the underlying security can sometimes change rapidly, especially
when the security price is changing rapidly. The expected volatility of the
security is the only input to the Black–Scholes f ormula that is not directly
observable. In fact, volatility is usually inferred from the option price itself by
using a pricing model. Sensitivity of option prices to changes in interest rates,
rho, receives less attention than delta and vega because interest rates generally
change quite slowly, although interest rate changes are relatively more impor-
tant for fixed-income derivatives.2
To illustrate the magnitude of the sensitivity measures and how they
might be used in risk management, we provide numerical values in Table
6.4 f or call and put options at various strike prices and some basic option
strategies. The values were calculated by using the Black–Scholes formula for
options with one month to expiration when the underlying security price is
$100, the interest rate is 2.00%, and volatility of the underlying security is
40.0%, similar to the prior numerical examples in this chapter. Using this
set of parameters, we note that call options at lower strike prices have higher
values and put options at lower strike prices have lower values. For example,
the 90-strike call has the highest price, at $11.195, whereas the highest priced
put option is the one with the 110 strike, at $11.242. Panel A of Table 6.4
provides the greeks for the five calls, and Panel B provides the greeks for the
five puts. For example, the 100-strike call and put options have the same cor-
responding greek values as shown in Table 6.3.
2
And, of course, time to expiration changes slowly over time, at a well-known constant rate!

Table 6.4 Sample Sensitivity Measures

Position or
Price Delta Gamma Theta Rho Vega
Strategy
A. Call option
Call at X = 90 11.195 0.838 0.021 –0.043 0.060 0.071
Call at X = 95 7.527 0.697 0.030 –0.063 0.052 0.101
Call at X = 100 4.684 0.529 0.034 –0.073 0.040 0.115
Call at X = 105 2.689 0.363 0.032 –0.069 0.028 0.108
Call at X = 110 1.425 0.226 0.026 –0.056 0.018 0.087
B. Put option
Put at X = 90 1.045 –0.162 0.021 –0.038 –0.014 0.071
Put at X = 95 2.369 –0.303 0.030 –0.058 –0.027 0.101
Put at X = 100 4.517 –0.471 0.034 –0.067 –0.043 0.115
Put at X = 105 7.514 –0.637 0.032 –0.064 –0.059 0.108
Put at X = 110 11.242 –0.774 0.026 –0.050 –0.074 0.087
C. Security and additional strategies
Security 100.000 1.000 0.000 0.000 0.000 0.000
Covered call
at 110 98.575 0.774 –0.026 0.056 –0.018 –0.087
Protective put
at 90 101.045 0.838 0.021 –0.038 –0.014 0.071
Straddle at 100 9.201 0.058 0.069 –0.014 –0.003 0.230
Delta-neutral
straddle,
put ratio = 1.12 9.753 0.000 0.073 –0.149 –0.008 0.244
Bull call
spread at
95 and 105 4.838 0.334 –0.002 0.007 0.024 –0.008
Vega-neutral
bull call
spread, call
ratio = 0.93 5.025 0.359 0.000 0.002 0.026 0.000
Note: Values are calculated from the Black–Scholes model with parameter values of S 0 = $100,
T = 1/12 (30.4 days), r = 2.00%, and σ = 40.0%.
Panel C of Table 6.4 lists the greeks for the underlying security, currently at
S0 = $100, and various option strategies. The security has a delta of exactly 1 and
gamma of exactly 0 by definition, in that the price of the security always moves
one-for-one with changes in itself. The sensitivity measures theta, rho, and vega

are all 0, by definition, for the underlying security. The covered call position nets
out the $1.425 price received for writing a 110-strike call option, for a total value
of $98.575. Note that the delta of the covered call position is 1 minus the delta of
the 110 call option, 1 – 0.226 = 0.774, which is equal to the absolute value of the
delta in the 110 put option because of put–call parity. Similarly, the price of the
protective put position is $100 plus the price of a 90-strike put, $1.045, and the
delta of the protective put at 90 is equal to the delta of 90-strike call.
Panel C of Table 6.4 also shows the values for an at-the-money straddle
strategy, which includes the simultaneous purchase of a 100-strike call option
and 100-strike put option, f or a total cost of 4.684 + 4.517 = $9.201. The
delta of the straddle is quite low, at 0.529 – 0.471 = 0.058, meaning that the
value is not very sensitive to movements up or down in the underlying secu-
rity price. Indeed, the intent of a straddle strategy is to benefit from increases
in volatility, as shown by the relatively high vega of 0.230, without making
any significant bet on the direction of change in the underlying security price.
Specifically, the vega of 0.230 indicates that a 1 percentage point increase in
volatility, from 40% to 41%, will increase the value of the straddle position by
23.0 cents, a return of 0.230/9.201 = 2.50%. The straddle is known as a long
volatility strategy because it increases in value with an increase in volatility.
The slightly positive value of the straddle’s delta indicates it is not per-
fectly neutral to changes in the underlying security price, but that sensitivity
can be strategically adjusted. In general, suppose an investor has a portfolio,
V, consisting of one unit of Asset 1 and h units of Asset 2, V = A1 + hA 2. The
change in the value of the portfolio as the security price changes is
∆V = ∆1 + h∆ 2 , (6.4)
where ∆ is defined as a change in the value of an asset or portfolio resulting
from a change in S0. Solving for the hedge ratio in Equation 6.4 gives
∆V − ∆1
h= . (6.5)
∆2
A special case of hedging, called a delta-neutral hedge, occurs when the
desired net delta of the portfolio is zero. To create a delta-neutral hedge, we
set ∆ V equal to zero in Equation 6.5, which gives the hedge ratio:
∆1
h=− . (6.6)
∆2
In the straddle strategy, the first asset is the 100-strike call and the sec-
ond asset is the 100-strike put, so a delta-neutral hedge can be constructed
by buying –0.529/–0.471 = 1.12 puts f or each call option. As shown in
Table 6.4, the result of this modified straddle is an option strategy that
remains long volatility, with a vega of 0.244 but a delta of exactly zero.

The delta of the call and put options are not constant, as evidenced by their
nonzero gammas, so once the security price begins to change, the 1.12
put-to-call ratio might have to be adjusted to keep a delta-neutral posi-
tion. To further mitigate against risk because of changes in the price of the
underlying security, hedgers can also create positions that are both delta
and gamma neutral.
The same measures of hedging can be applied to other option strategies.
Table 6.4 contains a standard bull call spread created by buying a 95-strike
call and selling a 105-strike call, for a total price of 7.527 – 2.689 = $4.838.
As intended, the bull call spread has a positive delta, meaning that the holder
benefits f rom increases in the price of the underlying security. Specifically,
the delta of 0.334 indicates that a $1 increase in the underlying security price,
f rom $100 to $101, will increase the spread value by 33.4 cents, a return of
0.334/4.838 = 6.90%. The –0.008 value of vega in the bull spread indicates
some residual sensitivity to changes in security volatility even though the
strategy includes buying one option and writing another.
As in the case of delta neutrality, to achieve a perf ectly vega-neutral
spread, we calculate the ratio of the vega values of the 95-strike call and
105-strike call, 0.101/0.108 = 0.93. Specifically, a bull call spread that writes
0.93 105-strike calls for every 95-strike call is perfectly vega neutral, as shown
by the vega value of 0.000 in Table 6.4.
Portfolios of option positions can also be designed to be neutral to two sensi-
tivity measures—for example, delta and gamma—at the same time. The strategy
would need to include at least three (not two) separate positions, however, and the
hedge ratio calculations would require a solution of two simultaneous equations,
one f or each of the neutrality conditions. Similarly, a portf olio of at least four
option positions could be designed to be neutral to three sensitivity measures—
say, delta, gamma, and vega—by solving three simultaneous equations.
One key concept here is that the delta of a strategy is simply the sum of the
deltas of the individual positions within the strategy, and the same is true for vega
and other sensitivity measures. Another important concept is that the sensitivity
measures are additive in their combined impact on a single position. For example, the
total change in a call option price as the various parameters change is
 1 
∆C =  ∆ c + γ c ∆S  ∆S + θc ∆T + ρc ∆r + ν c ∆σ, (6.7)
 2 
where
∆C = change in call option price
∆S = change in security price
∆T = change in time to expiration
∆r = change in interest rates
∆σ = change in volatility

Note that the impact of a change in the underlying security price is based on both
the delta and gamma. For example, the call option in Table 6.3, with parameters
S0 = $100, X = $100, T = 1/12, r = 2.00%, and σ = 40.0%, has a price of $4.684.
Suppose that the underlying security price increases by $1, from $100 to $101,
and that, at the same time, the volatility estimate drops 2 percentage points,
from 40.0% to 38.0%. For simplicity, we will assume that no time has passed
and that the interest rate remains unchanged. According to Equation 6.7, the
combined impact of these parameter changes on the price of the call option is
 1 
∆C = 0.529 + 0.034(1.00)  (1.00) − 0.073(0) + 0.040(0) + 0.115(−2)
 2 
= 0.316,
so the new price is 4.684 + 0.316 = $5.000. The increase in the underlying secu-
rity price, accounting for both the delta and gamma effects, would increase the
call option price to $5.230, but the decrease in volatility offsets the movement in
the security price somewhat, bringing the option price back down by 23.0 cents,
to exactly $5.00, which results in a smaller net increase in the call option price.
Alternative Ways to Create Option Effects

Call and put options are not always available for hedging a specific underlying
security. Moreover, a particular option may be expensive (i.e., have a high implied
volatility) or transaction costs may be prohibitive. So, methods f or replicating
option-like payoffs are useful. In this section, we discuss synthetic security cre-
ation based on the principle of put–call parity and then describe the process of
dynamic hedging using only the underlying security to create option-like payoffs.
By moving the terms around, the basic European put–call parity relation-
ship can be expressed in a number of different algebraic forms, but a common
one that isolates the current price of the call option is
X
C0 = S0 + P0 − . (6.8)
(1 + r )T
Equation 6.8 shows that the call option can be replicated by the underlying
security plus the corresponding put option minus a cash-equivalent security
or riskless bond. In other words, a synthetic call option can be created by buy-
ing the security and the put option, with most (although not all) of the cost
covered by borrowing the present value of X. Specifically, the combination
of securities on the right side of Equation 6.8 would produce the same risk–
return payoff as buying the call option directly.
An alternative form of the put–call parity relationship,
X
P0 = C0 + − S0 , (6.9)
(1 + r )T

indicates that an investor can create a synthetic put option by buying the call option
and investing the present value of X at the risk-free rate, with most (although not
all) of the cost covered by the proceeds from shorting the underlying security.
Again, the combination of securities on the right side of Equation 6.9 would
produce the same risk–return payoff as buying the put option directly.
In f act, the payoff of the underlying security itself can be replicated by
buying a riskless bond with a face value of X, buying a call option, and writ-
ing a put option—according to another configuration of put–call parity,
X
S0 = + C0 − P0 . (6.10)
(1 + r )T
In a similar way, a riskless bond can be constructed by buying the underlying
security, buying a put option, and selling a call option.
We can also leave two terms on each side of the put–call parity formula to
create a synthetic covered-call position:
X
S0 − C0 = − P0 . (6.11)
(1 + r )T
On the lef t side of Equation 6.11, the traditional covered call position is
established by buying the security and selling the call option, but the right
side indicates that an equivalent position is to buy a riskless bond at a dis-
count with a face value of X and sell the put option.
Finally, a synthetic protective put can be created by buying a riskless bond
at a discount with a face value of X and buying a call option:
X
S0 + P0 = + C0 . (6.12)
(1 + r )T
This configuration is of ten called a “90–10 strategy” because approxi-
mately 90% of the investor’s capital is held in cash with 10% used to purchase
call options.
Another way to create option-like effects is through dynamic hedging,
the same process we used in Chapter 5 to justify the multiperiod binomial and
the Black–Scholes option-pricing models. In its most general form, dynamic
hedging requires a replicating portfolio, R, with positions in the underlying
security, S0, and a riskless bond or cash-equivalent security, B:
R = ( w) S0 + (1 − w) B, (6.13)
where w is the proportion of the replicating portfolio invested in the under-
lying security. The change in replicating portfolio value for a change in the
price of the underlying security is
∆R = ( w)1 + (1 − w)0
(6.14)
= w,

so the process of dynamic hedging requires that the investor keep the propor-
tion of the portfolio invested in the underlying security, w, equal to the delta
of the strategy to be replicated.
Suppose, for example, that an investor is concerned about price declines
and wants to replicate a protective put. The investor knows that according to
put–call parity, the delta of a protective put is equal to the delta of the cor-
responding call, a number between 0 and 1, depending on the moneyness of
the call and the other option parameters. For instance, suppose the underly-
ing security is a stock priced at $100, as in Table 6.4, and the investor wants
to replicate the value of a one-month protective put at $95. The delta of the
protective put strategy is 0.697 (1.0 – 0.303), so the investor with $100,000
to hedge buys 697 shares at $100 each and invests the remaining $30,300 in
a cash account. If the price of the stock falls, the investor incurs only a partial
loss, similar to the loss incurred if the entire $100,000 were invested in a pro-
tective put strategy. But as the price declines, the investor needs to reduce the
proportion of the replicating portfolio invested in stocks to maintain a delta
hedge equal to a protective put strategy. Specifically, the delta of the protec-
tive put strategy decreases with declines in the stock price, according to the
gamma value of 0.030 in Table 6.4. Thus, for a $1 decline in the stock price,
the investor needs to sell about 30 shares to reduce the replicating portfolio’s
delta to match the new delta of the protective put strategy, leaving 697 – 30
= 667 shares. If the stock price increases by $1, the protective put replicator
needs to buy 30 more shares using cash in the portfolio. This approach is the
classic put replication strategy used by so-called portfolio insurance providers.
As with arbitrage-f ree option pricing itself , option strategy replication
through dynamic hedging assumes relatively smooth changes in the underly-
ing security price with no large or sudden jumps. This assumption may not
always hold, as users of portfolio insurance strategies found out in the October
1987 equity market crash. Moreover, the continual buying and selling of shares
to maintain a nearly perf ect hedge involves high transaction costs. Because
buying and selling the actual underlying security—for example, the S&P 500
Index portf olio—could be prohibitively expensive, investors sometimes sub-
stitute futures contracts for the underlying security, thus reducing transaction
costs and increasing the speed of execution.
Implied Volatility Smiles and Term Structure

The existence of option contracts for a range of strike prices on an underlying
security allows option analysts to measure aspects of the probability distribu-
tion that are not directly observable without option markets. Similarly, option
contracts with different times to expiration can be used to forecast how the
volatility of the underlying security is expected to evolve over time. Both the

detailed probability distribution and the term structure of volatility perspec-

tives use the concept of implied volatility, defined as the volatility parameter
that justifies a quoted option price.
For example, Table 6.5 shows September call option quotes for a range
of strike prices for Apple Inc. (AAPL) shares on Friday, 11 August 2012,
when AAPL closed at $621.70. Each quote yields an implied volatility,
backed out of the Black–Scholes formula with T = 0.100 (approximately five
weeks) and r = 0.20%. Note that Apple will not pay a dividend prior to the
September expiration date, so these American-style options can be reason-
ably valued by using the European-style Black–Scholes f ormula. Under a
lognormal probability distribution, as was originally assumed in the Black–
Scholes model, the implied volatilities are assumed to be equal for all strike
prices in the table.
However, the volatilities implied by the option quotes in Table 6.5
decrease f rom 26.75% f or the deeply in-the-money 560-strike call to
20.83% f or the out-of -the-money 660-strike call. The pattern indicates
a skewed probability distribution for AAPL returns—a f at lef t tail com-
pared with the more symmetrical lognormal distribution. Interestingly, the
implied volatility does increase slightly with the more deeply out-of-the-
money 680-call, suggesting that the right tail of the probability distribu-
tion may also be a little fat.
Table 6.5 Implied Volatilities of AAPL at Various

Strike Prices, 11 August 2012
Implied
Strike Call Price Quote ($) Volatility (%)
560 64.40 26.75
580 46.50 24.51
600 30.55 22.75
620 17.95 21.74
640 9.25 21.11
660 4.20 20.83
680 1.85 21.22
When the implied volatilities are plotted against the strike price, as in
Figure 6.11, the curve forms what analysts call a smile (if the curve is sym-
metrical) or, in this case, a smirk because there is only a little increase in vola-
tility on the right side of the chart. Many large-cap individual stocks in the
equity market exhibit this kind of skewed left tail, suggesting that the implied
return probability distributions are routinely nonnormal.

Figure 6.11. Implied Volatilities from AAPL Call Options
Implied Volatility
28
26
24
22
20
540 560 580 600 620 640 660 680 700
Strike Price ($)
A similar kind of implied volatility analysis can also be conducted by

using different option maturity dates instead of different strike prices. These
time-series versus cross-sectional implied volatility calculations allow ana-
lysts to examine what is sometimes considered the term structure of risk in
the underlying security. For example, on the same date as in Table 6.5, the
price quote f or the October (rather than September) 620-strike-price call
option for Apple shares was $26.65. The volatility implied by this price quote
adjusted f or the longer time to expiration in the Black–Scholes f ormula
was 24.71% instead of 21.74%. The volatility implied by the even f urther
out November 620-strike call option adjusted f or the even longer time to
expiration and the early November quarterly dividend f or Apple was even
higher, 27.13%. These implied volatility calculations suggest that the risk
of the underlying security—in this case, Apple shares—was f orecasted by
investors to increase over the next few months, as was the risk of most large-
cap domestic stocks in early August 2012.
The volatility implied f rom options on market indices, in addition to
index levels themselves, are now routinely provided as market indicators. For
example, VIX, the Market Volatility Index for the Chicago Board Options
Exchange, is the volatility implied by the price of options on the S&P 500.
As of the close of trading on 20 August 2012, the CBOE quoted the VIX as
14.30, meaning the annualized volatility of the S&P 500 implied by the vari-
ous option prices with September (one-month) expiration was 14.30%. The

VIX quotes for September and longer-maturity option expiration dates as of

mid-August 2012 are provided in Table 6.6. Although not always the case,
the VIX quotes are higher f or longer-term expiration dates—f or example,
16.45 for October expiration and 19.76 for December (five-month) expiration.
The pattern of VIX quotes indicates that in August 2012, market partici-
pants expected the volatility of the S&P 500 to be lower over the next month
than further in the future. The near-term VIX was more than 30% in August
2011, when the market had recently experienced considerable turbulence, and
the term structure was downward sloping, with lower values for more distant
option expiration dates.
Table 6.6 VIX at Various Expiration Dates,

as of Mid-August 2012
Expiration Month Quote
September (near term) 14.30
October 16.45
November 18.29
December 19.76
December 2013 24.75
December 2014 26.81
Conclusion
Options and futures have many similarities in terms of their ability to manage
the risk of investment positions and to create market exposure synthetically.
The fundamental hedging principles are the same, but the asymmetry inherent
in options makes hedging with options more complex and creates opportuni-
ties not generally available with f utures contracts. Short-term hedging using
options involves a number of sensitivity parameters, including delta, which
measures the sensitivity of the option price to a change in the underlying
security price. Quoted option prices provide a measure of underlying security
volatility that can be used to value other options on the same security and to
forecast future volatility. In summary, both option and futures contracts can be
important tools for managing investment risk, but the specific pricing struc-
tures and applications differ considerably between options and futures.

Appendix. Interest Rate Concepts
The use of fixed-income derivatives—f or example, U.S. Treasury bond

f utures—requires some background in basic interest rate concepts. This
appendix reviews three topics concerning interest rates and fixed-income
securities that are relevant to using fixed-income derivatives: simple ver-
sus compound interest rate quotations, the term structure of interest rates,
and measuring the interest rate risk of bonds using duration, convexity, and
DV01—the dollar value of a 1 bp change in the interest rate.
Interest Rate Quotations

Investors generally think in terms of annualized interest rates, but interest rates
over a shorter period are annualized in financial mathematics in at least two
distinct ways—simple interest and compound interest. For example, monthly
interest earned on a certificate of deposit or paid on a mortgage at a commer-
cial bank is annualized by using a simple interest calculation. Specifically, if a
customer earns 20 bps per month on the balance in a savings account, the bank
might quote an annualized percentage rate of 12 × 20 bps = 2.40%. This simple
interest calculation does not account for the interest earned each month on the
interest f rom prior months, the effect of compounding. In f act, the effective
annual rate (EAR) of return, or compound interest over the year, in this numeri-
cal example is (1 + 0.0020)12 – 1 = 2.43%, meaning that for $100 invested at the
beginning of the year, the account will actually contain $102.43 at the end of
the year, not $102.40.
At the current (spring 2012) low interest rates that prevail in many
developed economies, the difference in numerical values between quoting
conventions may be small, but it is still conceptually important. Although
we do not cover all of the various quoting conventions here, we will men-
tion a f ew that are common in dealing with fixed-income derivatives:
money market yield (f or euro deposits), discount rate basis (f or Treasury
bills), and bond-equivalent yield (f or bonds and notes). The rates quoted
in these various fixed-income markets can be compared with each other
by converting them to a common basis—the effective annual rate that
measures the true increase in dollar value. We will also mention the idea
of continuously compounded rates of return, which are of ten used in option-
pricing models.
The annualized money market yield is a simple interest rate, r, quoted with
the twist that the number of periods is based on a 360-day year divided by the
number of days over which interest is paid. The dollars of interest paid over t

days is divided by the initial dollars of principal and then multiplied by 360
over t:
Interest  360 
r= . (A.1)
Principal  t 
So, for example, if interest of $0.20 is paid on principal of $100 after 10
days, the quoted money market rate would be
0.20  360 
r=
100.00  10 
= 7.20% .
The EAR, which better reflects the economic reality of the gain, would be
365 /10
 0.20 
EAR = 1 + −1
 100 .00 
= 7.57% .
T-bills, which are purchased at a discount to face value, do not pay inter-
est directly. They are quoted on a bank discount rate basis and also use the
convention of a 360-day year. The bank discount rate is not a true return cal-
culation, in that the investor’s gain, or dollar difference between the purchase
price and face value payoff, is divided by the final, rather than the initial, cash
flow. Specifically, the dollars of discount f rom the face value are divided by
face value and then multiplied by 360 over t days:
Discount  360 
d= . (A.2)
Face value  t 
For example, if a T-bill with 20 days to maturity and a face value of $1,000 is
selling for $996, the rate quoted on a bank discount basis is
4  360 
d=
1, 000  20 
= 7.20% ,
whereas the EAR would be
365 / 20
 4 
EAR = 1 +  −1
 996 
= 7.59% .
The yield on T-bonds, which pay interest every six months, is a simple
interest rate calculation in that the semiannual yield, or interest payment
divided by price, is simply doubled to arrive at the bond-equivalent yield:
Coupon
y= ( 2) . (A.3)
Price

Thus, the only distinction between the bond-equivalent yield and EAR is
simple versus compound interest. Specifically, if a $1,000 f ace value T-bond
has exactly six months to maturity and pays a coupon of $36, the bond equiva-
lent yield is
36
y= ( 2)
1000
= 7.20% ,
whereas the EAR is
2
 36 
EAR = 1 +  −1
 1000 
= 7.33% .
The continuously compounded rates in option models, such as the Black–
Scholes f ormula, use continuous time mathematics. The notion of a con-
tinuously compounded rate can be illustrated by increasing the f requency of
compounding—that is, using shorter and shorter periods. For example, the
bond-equivalent yield of 7.20% led to a 7.33% EAR because of semiannual
compounding. If a commercial bank advertised a 7.20% savings rate com-
pounded monthly, the EAR would be
12
 0.0720 
EAR = 1 + − 1 = 7.44% ,
 12 
and with daily compounding, it would be 2 bps higher, at
365
 0.0720 
EAR = 1 + − 1 = 7.46% .
 365 
The extension to continuous time uses natural logs [Excel function LN()] and
the exponents of the natural number e = 2.17828 [Excel f unction EXP()].
Specifically, the relationship between a continuously compounded rate c and
the EAR is given by
EAR = ec − 1 , (A.4)
so a 7.20% annual percentage continuously compounded has an EAR of
EAR = e0.0720 − 1 = 7.47% ,
which is only 1 bp higher than with daily compounding.

The inverse f unction, to translate an EAR into a continuously com-
pounded rate, is given by
c = ln(1 + EAR ). (A.5)

For example, the risk-f ree rate parameter in the Black–Scholes f ormula
reviewed in Chapter 5 is a continuous rate, which will be slightly lower than
the effective annual rate or actual economic gain over a year, as calculated in
standard “discrete time” financial mathematics.
The Term Structure of Interest Rates

The term structure of interest rates describes the annualized rate or yield
offered by fixed-income securities across various maturities, all measured at
one point in time. When these yields are plotted against time to maturity,
from short term to long term, the resulting figure is called a yield curve. A
flat yield curve indicates that short-term interest rates are currently equal
to long-term interest rates. For most of the 20th century, the U.S. dol-
lar yield curve has been upward sloping, meaning that long-term interest
rates were higher than short-term rates. But this was not always the case.
For example, the yield curve for Treasury securities was downward sloping
in the early 1980s, when short-term interest rates were higher than long-
term rates. As of the writing of this book, interest rates f or most devel-
oped countries are quite low by historical standards, but the yield curves
are still upward sloping. For example, Figure A.1 plots the yield on U.K.
Figure A.1. U.K. (British Pound) Yield Curve
Bond Yield (%)

5
0
1 2 3 4 5 6 7 8 9 10
Years to Maturity

government bonds with maturities f rom 1 year to 10 years as of March

2012. Note that, although f or most of this book, we use U.S. financial
market examples and currency, we are using a non-U.S. bond in this exam-
ple because the coupons are paid annually. The semiannual coupons and
associated bond-equivalent yield of U.S. Treasury securities complicate the
numerical examples and intuition.
One of the reasons for an upward-sloping yield curve might be that holders
of long-term bonds require a risk premium reflecting uncertainty about the path
of future interest rates. Markets often manifest an upward-sloping yield curve,
suggesting a gradual increase in short-term rates in the f uture. For example,
suppose the current one-year interest rate (yield on a one-year, zero-coupon,
risk-f ree bond) is 2% and that market participants expect that the yield on a
one-year bond one year from now will be 4% and that the one-year yield on a
one-year bond two years from now will be 6%. What will the price and yield of
a two-year bond be right now with those expectations? Using basic time-value-
of-money financial mathematics, an analyst will find that the current price of a
two-year bond with a face value of 100 is
100
= 94.27
(1 + 0.02)(1 + 0.04)
and the annualized yield based on this price is
1/ 2
 100.00 
 94.27  − 1 = 3.00% .
 
Similarly, the current price of a three-year bond with a face value of 100 is
100
= 88.93,
(1 + 0.02)(1 + 0.04)(1 + 0.06)
and the annualized yield based on this price is
1/ 3
 100.00 
 88.93  − 1 = 3.99% .
 
In this numerical example, a yield curve would plot spot rates of 2.00%,
3.00%, and 3.99% (almost 4%), for, respectively, the one-year, two-year, and
three-year maturity bonds. Even if analysts did not know the underlying short-
term interest rates of 2%, 4%, and 6%, they could easily infer from the shape of
the yield curve that short rates in the future were expected to be higher.
In fact, given two successive spot rates, we can calculate the forward rate
as a forecast of the f uture short-term interest rate implied by the yield curve.
Intuitively, the annualized interest rate over two years would be the average of
the first and second year, so if the first year is 2% and the average is almost 3%,
then the second year must be about 4%. Similarly, an average of three numbers

of almost 4%, where the first two numbers are 2% and 4%, implies that the
third number is about 6%. These arithmetic averages are not exact because rates
of return are multiplicative, but the intuition is fairly straightforward.
We will use the f ollowing terminology, with associated mathematical
notation, in the context of more exact term structure analysis.
Terminology Notation Definition

Short rate rt Short-term interest rate over period t (e.g., year)
Yield on a bond that matures at the end of
Spot rate yt period t
The future short-term interest rate over period t
Forward rate ft implied by two successive spot rates
The word short in this context comes f rom the idea of short-term rates, and
the word spot implies right now, as opposed to a rate that might occur in the
f uture. The phrase pure spot rate emphasizes that the bonds in question are
zero-coupon bonds, so the annualized yield is uncontaminated by the impact
of interim cash flows. The phrase implied f orward rate emphasizes that the
forward rate is a calculated value that is implied by the spot rates.
The exact algebraic relationships that account f or the multiplicative
nature of returns can be derived from the time-value-of-money mathematics.
Specifically, a multiperiod spot rate (yield on a zero-coupon bond) is a func-
tion of the short-term interest rates that will prevail over the life of the bond:
1/ t
yt = [ (1 + r1 )(1 + r2 ) ... (1 + rt ) ] − 1. (A.6)
More importantly, a forecast of the short-term interest rate that will prevail
over a f uture period t can be inferred f rom two successive spot rates in the
current market:
ft =
(1 + yt )t − 1. (A.7)
(1 + yt −1 )t −1
Because the short-term rates that will eventually prevail in the marketplace
are not known before the fact, the forward rate is typically used by analysts as
a forecast or expected value of the eventual short rate:
ft = E (rt ). (A.8)
The actual short rate realized after the fact, rt, might end up being above or below
the analysts forecast, ft, but the calculation and concept of forward rates is impor-
tant in many fixed-income applications, including hedging with derivatives.
Table A.1 illustrates the calculation of pure spot rates and forward rates
for U.K. government bonds in March 2012. The annual coupon rate and yield

Table A1. U.K. Bond Spot and Forward Rates in March 2012
Years to Yield to
Maturity Coupon Rate Maturity Price Spot Rate, y Forward Rate, f
1 4.50% 0.44% 104.042 0.440%
2 2.25 0.47 103.535 0.470 0.501%
3 2.75 0.62 106.312 0.624 0.933
4 2.00 0.93 104.182 0.942 1.900
5 1.75 1.21 102.605 1.228 2.382
6 5.00 1.47 120.132 1.545 3.143
7 4.50 1.73 118.115 1.823 3.507
8 4.75 1.98 120.309 2.108 4.126
9 3.75 2.23 112.272 2.360 4.399
10 4.00 2.42 113.886 2.582 4.602
to maturity of the bonds in the first two columns are inputs to the bond price
calculations in the third column in standard time-value-of-money functions.
More complex calculation procedures (not covered here) could determine
the pure spot rates, defined as the yield that would prevail on a zero-coupon
bond at each maturity. Note that the spot rates, yt, are close but not exactly
equal to the coupon bond yields, which are a complex average of the spot rates
over the life of the bond. The forward rate, ft, at each maturity is calculated
from the current and prior spot rate, yt and yt–1, by using Equation A.7. For
example, the short-term interest rate in the United Kingdom was 0.440% in
March 2012 and the one-year forward rate is slightly higher, at 0.501%. The
term structure of interest rates indicates that one-year forward rates increase
quickly after the second year and rise as high as 4.602% at the beginning of
the tenth year.
Measuring Interest Rate Risk

The price of long-term fixed-income securities changes as interest rates
change, and being able to describe how the price will change is important
for those trying to hedge with derivatives. Duration and convexity are two
measures of interest rate risk that help describe how the price of the bond
will change as its yield to maturity changes. Figure A.2 plots how the price
of a bond changes with changes in yield. Note that bond prices decrease with
higher yield and increase with lower yield, although the f unction is curved
rather than linear. Duration provides a measure of the slope of the curve at
a given price and yield, as shown by the dotted line tangent at a given point
on the curve in Figure A.2. Convexity is a measure that helps correct the

Figure A.2. Bond Price as a Function of Yield
Price (P)
Yield to Maturity (y)
linear extrapolation of a bond price back to a more accurate price based on the
degree of curvature in the price–yield curve.
Frederick Macaulay (1910) coined the term duration in the early 20th cen-
tury for the weighted average time to payment of a security’s cash flows, where
the weights in the averaging process are based on the present value of each cash
flow over the total price. For example, a bond with a 10-year maturity and fixed
coupons might have an average time to payment of about 8 years, where the
average puts more weight on the payment of principal in the 10th year than
the smaller coupon payments in Years 1–9. Using calculus, we can show that
this calculation of average time to maturity is equivalent to the negative of the
change in bond price for a given change in yield. The most commonly used form
of duration is modified duration, defined as the percentage change in price for a
change in yield:
∆P / P
D* =
∆y
(A.9)
%∆P
= .
∆y
The asterisk notation differentiates modified duration f rom Macaulay dura-
tion, D. Specifically, modified duration is equal to the Macaulay duration
(i.e., average time to maturity) divided by 1 plus the yield,
D
D* = .
( + y)
1 (A.10)

The first three columns of Table A.2 provide a detailed calculation of the
price of a 10-year bond with annual coupon of 4% and priced to yield 5%.
The bond price of 92.28 shown at the bottom of the third column of Table
A.2 is simply the sum of the present values of the cash flows:
T CFt
P= ∑ . (A.11)
y )t
t =1 (1 +
The price of a fixed-coupon bond expressed as a percentage of par or face value
has a somewhat intuitive closed-form (i.e., without summations) formula:
c 1  1
p= 1 − + , (A.12)
y  (1 + y )  (1 + y )T
T
where
c = coupon rate
y = yield
T = number of periods to maturity
The first term in Equation A.12 captures the present value of the coupons,
and the second term captures the present value of the eventual face value pay-
ment. For example, the bond in Table A.2 has a price relative to par of
0.04  1  1
p= 1 − + = 0.9228,
0.05  (1 + 0.05)10  (1 + 0.05)10
Table A2. Duration and Convexity Calculations

t CFt PV(CFt) wt = PV(CFt)/P wt * t wt* t* (t + 1)
1 4.00 3.81 4.13% 0.04 0.08
2 4.00 3.63 3.93 0.08 0.24
3 4.00 3.46 3.74 0.11 0.45
4 4.00 3.29 3.57 0.14 0.71
5 4.00 3.13 3.40 0.17 1.02
6 4.00 2.98 3.23 0.19 1.36
7 4.00 2.84 3.08 0.22 1.73
8 4.00 2.71 2.93 0.23 2.11
9 4.00 2.58 2.79 0.25 2.51
10 104.00 63.85 69.19 6.92 76.11
Sums 92.28 100.00% 8.36 86.32
Notes: CFt stands for cash flow at time t, PV stands for present value, and wt stands for weight
for time t. The sums in the last two columns are for Macaulay duration and convexity. Using
Equations A.10 and A.15, we can calculate the modified duration and convexity, respectively, as
7.96 and 78.29.

or 92.28%. If coupons are paid semiannually and yield is quoted as twice

the semiannual rate, as is the case f or most bonds in the United States,
then appropriate adjustments (doubling or halving) must be made to the
variables—for example,
0.020  1  1
p= 1 − +
0.025  (1 + 0.025)  (1 + 0.025)20
20
= 0.9221 .
For simplicity and intuition, we will continue to discuss bonds for which the
underlying interest payment period is annual.
The fourth column in Table A.2 calculates weights based on the present
values of each cash flow, and the fifth column calculates the Macaulay dura-
tion, defined as the weighted average time to maturity of the bond,
T  CF 
t
D= ∑ t
t
t =1  P (1 + y ) 
T (A.13)
= ∑ wt t ,
t =1
= 8.36 ,
a duration of D = 8.36 years. The modified duration calculation requires one
more step,
D
D* =
( y)
1 +
8.36
=
(1 + 0.05)
= 7.96,
a modified duration of D* = 7.96 years. Modified duration also has a closed-
form formula for a fixed-coupon bond,
1 1 + T ( c − y ) / (1 + y ) 
D* = − . (A.14)
y T
c (1 + y ) − 1 + y
 
For example, using the parameter values of the bond in Table A.2 gives
1 1 + 10 ( 0.04 − 0.05 ) / (1 + 0.05 ) 

D* = − = 7.96 ,
0.05 10
0.04 (1 + 0.05 ) − 1 + 0.05
 
or, again, D* = 7.96 years.
In application, modified duration (hereaf ter simply duration) is not so
much a measure of time but of the price sensitivity of the bond to changes

in interest rates or yield, as noted in Equation A.9. For example, if the yield
on the bond in Table A.2 goes down by 10 bps, the duration of 7.96 indicates
that the approximate percentage increase in price will be –7.96 × (–10) = 79.6
bps. Similarly, if the yield drops by 20 bps, the duration of 7.96 indicates that
the approximate percentage increase in price will be –7.96 × (–20) = 159.2 bps.
Note that duration in this context is used as a simple multiplier against the
yield change, with a leading negative sign because bond prices move in the
opposite direction from a change in yield.
As shown by the dotted line in Figure A.2, duration is a linear
extrapolation based on the slope of the convex price–yield curve at a
given point. As a result, the estimated price change based on duration is
only approximate, and the error is bigger for larger changes in yield. For
example, if the yield on the bond in Table A.2 increases by 100 bps, from
5.00% to 6.00%, the estimated percentage price change will be –7.96 ×
100 = –796 bps, or –7.96 percentage points. But if Equation A.12 is used,
the actual price of the bond at the new 6.00% yield is 85.28, a –7.58 per-
centage point change.
To provide a more accurate representation of the interest rate risk in bond
prices, analysts also use the notion of convexity, based on a second derivative
in calculus. As shown in the last column of Table A.2, convexity can be cal-
culated by the summation
T  CF 
t
C= ∑  t (t + 1)
t
t =1  P (1 + y )  (A.15)
T
= ∑ wt t (t + 1),
t =1
which gives C = 86.32 as shown at the bottom of Table A.2.
Similar to duration, the convention is to modify convexity by dividing by
1 plus the yield squared,
C 86.32
C* = = = 78.29.
2
(1 + y ) (1 + .05)2
Modified convexity (hereafter simply convexity) does not have an intuitive
unit of measure. Although closed-form formulas for the convexity of fixed-
coupon bonds exist, they are complex and have little intuitive value or con-
ceptual interpretation. Convexity is used to obtain a more exact description of
the impact of changes in yield on the percentage change in price by using the
Taylor-series expansion formula:
∆P C * (∆y )2 (A.16)
= − D* (∆y ) + .
P 2

For example, the estimated percentage change in the price of the bond in
Table A.2 for a 100 bps increase in yield when both duration and convexity
are used is
∆P 78.29(0.0100)2
= −7.96(0.0100) +
P 2
= −7.57% ,
which is quite close to the previously discussed actual price change of
–7.58%.
To some extent, the motivation for the original mathematics of dura-
tion and convexity has disappeared because computer technology allows one
to calculate the actual price impacts of any interest rate change, but the
language and concepts associated with these two risk measures are deeply
embedded in fixed-income analysis and, theref ore, the analysis of deriva-
tive securities. For example, the “duration” of a bond futures contract may
change suddenly, rather than gradually, as different cheapest-to-deliver
(CTD) bonds become the best way to f ulfill the contract. Or consider
another example: A callable bond in which the upper portion of the price
curve that would be displayed in Figure A.1 is concave instead of convex is
said to exhibit “negative convexity,” in that duration for it decreases rather
than increases as interest rates increase.
Although a futures contract on a bond does not have a series of cash flows
over time like the underlying note or bond, the interest rate sensitivity or
effective duration can be derived from its relationship to the CTD security.
Using the equation for the fair value of a futures contract on a bond given in
Chapter 2, Equation 2.5, we find the duration of the f utures contract with
price F0 and CTD bond price PCTD to be
 PCTD 
 (1 + r ) , (A.17)
t
DF* = DCTD
*

 f F0 
where
f = delivery or conversion factor of the CTD note or bond
r = short-term risk-free rate
t = time to futures contract expiration
Note that the effective duration of the futures contract is related to the dura-
tion of the CTD bond. The term (1 + r)t is often dropped in the calculation
because it is close to 1 for a near-term futures contract.
If the investor were trying to hedge the interest rate risk of a bond
with price PB and duration DB* , the hedge ratio would include the change
in yield on that bond, ∆yB , relative to the change in yield of the CTD
bond, ∆yCTD :

DB*  PB   ∆yB 
h=−   . (A.18)
DF*  F0   ∆yCTD 
The two yield changes are often assumed to be equal, so the last term would
be equal to 1. Combining Equations A.17 and A.18 allows us to calculate the
hedge ratio by using values for the bond to be hedged and the CTD bond:
DB*  f PB  1  ∆yB 
h=−
*   t  , (A.19)
DCTD  PCTD  (1 + r )  ∆yCTD 
where, again, the last two terms are often assumed to be 1.
The dollar value change in a bond’s price for a 1 bp change in a bond’s
yield—that is, DV01—is closely related to the bond’s duration. Specifically,
modified duration is multiplied by bond price and by 0.0001 (i.e., 1 bp) so
that the price change is in dollars rather than a percentage:
DV01 = DB* PB (0.0001). (A.20)
For example, the DV01 for a bond priced at $1,000 with a modified duration
of 5.0 is
DV01 = 5.0 (1, 000 )( 0.0001)
= $0.50.
Thus, the DV01 can be used instead of duration to calculate the price impact
of a change in yield, measured in basis points:
∆PB = − DV01 ( ∆yB ) . (A.21)
For example, a 10 bp drop in the yield on the example bond would increase
the price by
∆PB = − $0.50 (−10) = $5.00,
or 0.5% of the initial $1,000 bond price, for a new price of $1,005.
Similarly, the DV01 for a futures contract is based on the futures duration
and the futures price:
DV01F = DF* F0 (0.0001). (A.22)
Finally, substituting Equation A.17 for the duration of a futures contract
into Equation A.22 gives a relationship between the f utures DV01 and the
DV01 of the CTD bond as
*
DCTD PCTD (0.0001) DV01CDT (A.23)
DV01F = (1 + r )t = (1 + r )t ,
f f
where the last term is often assumed to be 1.

Exercises
Futures Pricing
Exercise 1
Calculate the fair value of the following contracts with 25 trading days
(t = 25/250 = 0.10 years) to expiration and an effective annualized risk-f ree
interest rate of 1.5% for the 25-day period:
a. An equity index futures contract with the current index level of 1,364.10
and an annualized dividend yield of 2.1%.
b. A f oreign exchange f utures contract f or British pounds with the current
spot price of USD1.620/GBP and the foreign risk-free interest rate of 2.6%.
c. A U.S. Treasury bond f utures contract with the market price of the
cheapest-to-deliver (CTD) bond equal to 84 16/32 (84.500). The CTD
bond has a coupon rate of 5.0%, accrued interest of 0.375, and a delivery
factor of 0.9140.
Solutions
a. The fair value of the equity futures contract is
t
F0 = S0 (1 + r − d ) = 1, 364.10(1 + 0.015 − 0.021)0.10 = 1, 363.28.
The f utures price is slightly lower than the spot price because the divi-
dend yield of the underlying index is higher than the interest rate.
b. The fair value for the foreign exchange futures contract is
t 0.10
 1 + rd   1 + 0.015 
F0 = S0   = 1.620   = 1.618.
 1 + rf   1 + 0.026 
 
c. The fair value of the T-bond futures contract is
F0 =
( S0 + AI ) (1 + r )t =
(84.500 + 0.375) (1 + 0.015)0.10
= 92.999,
f 0.9140
where AI is the accrued interest adjustment.

Implied Repo Rates

Exercise 2
Calculate the implied repo rate if the actual market price of the equity
f utures contract in Exercise 1a were 1,366.70. How would an investor con-
struct an arbitrage position to earn this rate of return?
Solution
The futures contract implied repo rate can be found by rewriting the rela-
tionship as
1/ t
F 
r =  0  + d −1
 S0 
10
 1, 366.7 
=  + 0.021 − 1
 1, 364.1 
= 4.0%.
The arbitrage position would require buying a basket of stocks to replicate
the S&P 500 Index and selling the futures contract. At the expiration of
the contract, the investor would have earned an annualized 4.0% minus
any transaction costs to construct the portf olio. Tracking error between
the physical stocks and the index would add some variability to the arbi-
trage return.
Exercise 3
Calculate the implied domestic repo rate if the futures price in Exercise
1b were equal to USD1.630/GBP. What arbitrage positions would create this
rate of return?
Solution
The implied domestic repo rate can be found by rewriting the fair value
relationship as
1/ t 10
F 
rd =  0  (1 + rf ) − 1 =  11..630 
620 
(1 + 0.026 ) − 1
 S0 
= 9.1%.
To capture this return, the investor must convert dollars to pounds at the
current exchange rate of USD1.620/GBP, invest at the foreign interest rate of
2.6%, and sell the futures contract. When the principal and interest in pounds
are converted back into dollars and combined with the gains or losses on the

Exercises
futures contract, the realized dollar return on the strategy is 9.1% annualized
minus any transaction costs.
Basis and Calendar Spreads

Exercise 4
Suppose that on 1 August, the S&P 500 is at 1,345.3, with September
and December f utures prices as shown in the f ollowing table. Two weeks
later, on 15 August, the S&P 500 has f allen to 1,303.6, with the f utures
prices as shown in the following table.
1 August 15 August
Index 1,345.3 1,303.6
September settlement 1,342.6 1,301.8
December settlement 1,337.2 1,296.5
a. Calculate the nearby (September) f utures contract basis at each of the

two dates.
b. Calculate the calendar spread between the nearby (September) and
deferred (December) futures for each of the two August dates.
Solutions
a. The basis f or the September S&P 500 f utures is the spot minus the
f utures price. So, the basis on 1 August is 1,345.3 – 1,342.6 = 2.7, and
the basis on 15 August is 1,303.6 – 1,301.8 = 1.8. As is typical, the basis
declines as the contract settlement date approaches.
b. The calendar spread of 1 August is 1,342.6 – 1,337.2 = 5.4, and the cal-
endar spread on 15 August is 1,301.8 – 1,296.5 = 5.3. As is typical, the
calendar spread remains fairly constant over time.
Hedging Relationships
Exercise 5
Suppose an investor will receive a payment of 625 million yen in one
month as a Japanese bond position matures. The current exchange rate is
USD0.0125/JPY (or 80.0 yen per dollar), but the investor is concerned that
the yen will depreciate relative to the dollar over the next month.

a. Construct a simple hedge using the yen futures contracts, currently priced
at USD0.0127/JPY. How many contracts would be needed?
b. If the spot exchange rate decreases to 0.0121 over the next month and the
futures price decreases to 0.0124, what is the net result of the hedge for
the investor?
Solutions
a. The notional value of the yen f utures contract is 12,500 (see Table 1.1),
so to hedge a decline in the value of the yen (i.e., an increase in the JPY/
USD exchange rate), the investor would need to take a short position in
625,000,000/12,500,000 = 50 futures contracts.
b. The value of the 625 million yen at the final exchange rate of 0.0121 is
625,000,000 × 0.0121 = $7,562,500. The gain on the short futures posi-
tion of 50 contracts is 50 × 12,500,000 × (0.0127 – 0.0124) = $187,500,
for a total hedged value of 7,562,500 + 187,500 = $7,750,000. Note that
the total hedged value is still $62,500 less than the value of the bond if it
could have been immediately converted to dollars, 0.0125 × 625,000,000
= $7,812,500. The reason is that the hedge is subject to basis risk and the
basis in the futures contract increased from 0.0127 – 0.0125 = 0.0002 to
0.0124 – 0.0121 = 0.0003.
Exercise 6
Using the f ollowing cash and f utures prices, calculate the effect of a
Eurodollar hedge constructed using a stack compared with one using a strip.
What net advantage has been created by using the strip?
Roll Date Hedge Date

Now (t) (T)
Spot price, S 98.85 97.55 97.50
Nearby contract, F 1
97.50 97.45 —
Deferred contract, F 2
97.25 97.25 97.20
Solution
The net price of the hedge created using a strip is
( )
PT ( Strip ) = ST + F02 − FT2 = 97.50 + (97.25 − 97.20) = 97.55.
The net price of the hedge created using a stack would be

Exercises
( ) (
PT ( Stack ) = ST + F01 − Ft1 − Ft2 − FT2 )
= 97.50 + (97.50 − 97.45) + (97.25 − 97.20)
= 97.60.
The difference between the net price of the stack and strip is caused by the
change in the calendar spread from the initiation of the hedge (Time 0) to the
point of the roll (time t):
( ) (
PT ( Stack ) − PT ( Strip ) = F01 − F02 − Ft1 − Ft2 )
= (97.50 − 97.25) − (97.445 − 97.25)
= 0.05.
Interest Rate Concepts

Exercise 7
Currently, the term structure (effective annual rates on zero-coupon
bonds) is as follows.
Maturity Effective
(years) Annual Rate
1 y 1 = 2.05
2 y 2 = 2.23
3 y 3 = 2.41
a. Calculate the one-year implied forward rates for one and two years from now.
b. Calculate the annualized two-year implied forward rate for one year from
now.
Solutions
a. The one-year rate one year forward is
(1 + y2 )2 (1.0223)2
f2 = −1= − 1 = 2.41%,
(1 + y1 )1 (1.0205)1
and the one-year rate two years forward is
(1 + y3 )3 (1.0241)3
f3 = −1= − 1 = 2.77%.
(1 + y2 )2 (1.0223)2

b. The annualized two-year rate one year forward is
[(1 + f 2 ) (1 + f3 )]1/ 2 − 1 = [(1.0241) (1.0277)]1/ 2 − 1

= 2.59%.
Exercise 8
Consider an annual coupon bond with a face value of 100, exactly three
years to maturity, and a 5.00% coupon. It is priced to yield 1.95%.
a. Calculate the price of the bond.
b. Calculate the bond’s modified duration.
c. Calculate the bond’s DV01, defined as the change in dollar value associ-
ated with a 1 bp change in yield.
d. Use the bond’s modified duration to estimate the price impact of a 100
bps rise in yield to 2.95%.
e. Calculate the bond’s modified convexity.
f. Use the bond’s modified duration and modified convexity to estimate the
price impact of a 100 bp rise in yield to 2.95%.
g. Calculate the actual price of the bond at a yield of 2.95% and contrast
your answer to the estimates in Exercises 8d and 8f.
Solutions
a. The sum of present values of the cash flows is
5 5 105
1
+ 2
+ = 108.80.
(1.0195) (1.0195) (1.0195)3
The bond price relative to face value can also be calculated by the formula
c 1  1
p = 1 −  +
y  (1 + y )T  (1 + y )T
5.00  1  100
= 1 −  +
1.95  (1.0195)3  (1.0195)3
= 1.0880,
giving a price of $108.80.

b. Duration is the weighted average time to maturity of the bond’s cash
flows:
5 5 105
1
(1) + 2
(2) + (3) = 2.866,
(1.0195) (1.0195) (1.0195)3

Exercises
so the modified duration is 2.866/1.0195 = 2.81 years.

Modified duration can also be calculated by the formula
1 1 + T ( c − y ) / (1 + y )
D* = −
y T
c (1 + y ) − 1 + y
 
1 1 + 3 ( 0.0500 − 0.0195 ) / 1.0195
= −
0.0195 3
0.0500 (1.0195 ) − 1 + 0.0195
 
= 2.81.
c. The DV01 of the bond is

DV01 = DB* PB (0.0001) = 2.81(108.80 ) (0.0001) = 0.0306.
d. Using modified duration, a 100 bp increase in yield gives a drop in price

of –2.81(0.0100) = –281 bps, or –2.81%.
e. The convexity of the bond is
5 5 105
1
(1)(2) + 2
(2)(3) + (3)(4) = 11.284,
(1.0195) (1.0195) (1.0195)3
so the modified convexity is 11.284/(1.0195)2 = 10.86.
f . Using modified convexity and modified duration, a 100 bp increase in
yield gives a drop in price of –2.81(0.0100) + [10.86(0.0100)2]/2 = –276
bps, or –2.76%.
g. The actual price at a yield of 2.95% is
5 5 105
1
+ 2
+ = 105.80,
(1.0295) (1.0295) (1.0295)3
which is a 105.80/108.80 – 1 = –2.76% drop in price. The estimated price
impact of –2.81% found when using modified duration is an approxima-
tion. The refined estimate of –2.76% f ound when using both modified
duration and modified convexity is more accurate.
Hedge Positions
Exercise 9
Calculate the hedge ratio and the number of f utures contracts required
f or a short-term hedge of each of the f ollowing positions. Assume that all
futures contracts in this problem expire in three months (t = 0.25 years) and

that the effective annualized repo (risk-free) rate embedded in these contracts
is 2.00%.
a. Hedge a $50 million equity portfolio that has a beta of 0.9 relative to the
S&P 500. The S&P 500 is currently at 1,350 and has a dividend yield of
exactly 3.00%.
b. How would the solution in Exercise 9a change if the hedge horizon
was longer and equal to the three-month expiration of the equity index
futures contract?
c. Hedge a $50 million portf olio of corporate bonds using T-bond f utures.
Assume that corporate yields will change by 12 bps when T-bond rates
change by 10 bps. The modified duration for the corporate bond portfolio
is 6.3 years, and the modified duration for the T-bond futures is 8.7 years.
The average price of the corporate bonds is 94 12/32; the futures is priced at
96 l6/32; and the price of the CTD T-bond is 98 24/32.
d. Hedge a £40 million exposure when the annualized risk-f ree three-
month U.K. interest rate is 1.00%.
Solutions
a. The hedge ratio for the equity portfolio with a short hedge horizon is
−β −0.9
h= = = −0.902.
t
(1 + r − d ) (1 + 0.0200 − 0.0300 )0.25
The notional value per contract is 50 × 1,350 = $67,500, so the rounded
number of contracts required is
 Value hedged   50, 000, 000 

n = h  = −0.902   = −668,
meaning a short position in 668 S&P 500 futures contracts.
b. If the hedge is expected to be in place until the expiration of the futures con-
tract, the impact of the hedge will reflect the convergence of the futures con-
tract to the index. The hedge ratio would not need to be adjusted for the current
basis because the portfolio beta is 0.9. The number of futures contracts would be
 Value hedged   50, 000, 000 

n = h  = −0.9   = −667.
A larger number of contracts (668 compared with 667) is required when the
hedge is held for only a short time because little basis convergence will occur
and a change in the futures index will produce a slightly smaller change in

Exercises
the futures price as a result of the currently negative basis. Consequently, a

slightly larger number of contracts is needed for the hedge. The adjustment
is not particularly meaningful, however, in this case.
c. A cross-hedge can be constructed for the corporate bond portfolio with
T-bond futures because changes in corporate and Treasury interest rates
are assumed to be highly correlated. The hedge ratio for the portfolio is
DB*  F   ∆yB 
h=−   
DF*  B   ∆yF 
6.3  96.500   12 
=−
8.7  94.375   100 
= −0.889.
The price of the CTD bond is 98.750, so the notional value of each
f utures contract is 0.98750 × $100,000 = $98,750. The number of short
contracts required is
 Value hedged 
n = h 
 Contract size 
 50, 000, 000 
= − 0.889  
 98, 750 
= − 450.
d. The hedge ratio for the British pound exposure is

t 0.25
 1 + rf   1.0100 
h = −   = −  1.0200  = −0.998.
 1 + rd   
Given that the U.S. and U.K. interest rates are similar, the hedge ratio
is quite close to –1.0 and is of ten simply assumed to be exactly –1.000
in practice. Given the calculated hedge ratio of –0.998, however, and a
contract size of £62,500, the number of contracts required is
n = h 
 40, 000, 000 
= − 0.998  
 62, 500 
= − 639.
Exercise 10
Suppose an investor has a multi-asset portfolio consisting of the $50 million
stock portfolio in Exercise 9a, the $50 million bond portfolio in Exercise 9c,

and $25 million in cash—that is, weights of wS = 50/125 = 40%, wB = 50/125

= 40%, and 100 – 40 – 40 = 20% in cash. The investor would like a portfolio
that has the characteristics of a 60/30/10 stock/bond/cash portfolio, in which
the target equity portfolio has a standard beta of 1.0 and the target bond port-
folio has a duration of exactly 10.0 years. Without changing the actual physical
assets in the portfolio, how many futures contracts of what type are needed to
achieve the target portfolio weights and risk exposures?
Solution
The hedge ratio for the desired equity exposure is
wT − wS βS
hS = S
(1 + r − d )t
( 0.60 − 0.40 ) 0.900
=
(1 + 0.0200 − 0.0300)0.25
= 0.241,
meaning that a long equity f utures hedge is required to increase the equity
exposure and the equity beta. Specifically, the required number of S&P 500
futures contracts is
n = h 
 50, 000, 000 
= 0.241 
 67, 500 
= 179.
The hedge ratio for the desired bond exposure is
 wT D* − w D*   B   ∆y 
hB =  B T * B B     B 
 DF   F   ∆yF 
 
 0.30 (10.0 − 0.40 ) 6.3   94.375   12 
=     
 8.7   96.500   10 
= 0.065.
Even though the target weight of 30% is lower than the actual weight of 40%,
the desired duration of 10.0 is enough higher than the actual duration of 6.3
that a long bond futures position is needed. The number of contracts required is
 Value hedged   50, 000, 000 
n = h  = 0.065  98, 750  = 33.
 Contract size   

Exercises
Risk–Return Characteristics of Options

Exercise 11
This exercise considers several strategies in addition to those discussed
in Chapter 4 to illustrate the payoff patterns of options and some intu-
ition about their relative prices. The options in each strategy are f or the
same expiration date, but none of the underlying security is held, so these
strategies are spreads and generally considered to be somewhat specula-
tive, in contrast to hedges. Prepare a contingency table and payoff diagram,
including a dotted line for the payoff net of the initial cash flow, for each of
the following:
a. Short straddle. Sell a put and sell a call with the same strike price, X.
b. Bear put spread. Sell a put with a strike price of X1 and buy a put at a strike
price of X 2 (where X1 < X 2).
c. Ratio spread. Buy a call option at a strike price of X1 and sell two call
options with a strike price of X 2 (where X1 < X 2).
d. Butterfly spread. Buy two different call options at strike prices X1 and X 3
and sell two call options at strike price X 2 (where X1 < X 2< X 3). For this
problem, assume that X 2 is halfway between X1 and X 3.
e. Condor. Sell two different call options at strike prices X 2 and X 3 and buy
two different call options at strike prices X1 and X4 (where X1 < X 2 < X 3 <
X4). For this problem, assume that the difference between the two lower
strike prices, X 2 – X1, is equal to the difference between the two higher
strike prices, X4 – X 3.
f. Box spread. Buy a call option with strike price X l and sell a call option
with strike price X 2. In addition, sell a put option at strike price X1 and
buy a put option at strike price X 2 (where X1 < X 2).
Solutions
a. The short straddle is constructed by selling a put and a call option with
the same strike price. The contingency table for the short straddle follows.
ST < X ST > X
– Call option 0 – (ST – X)
– Put option – (X – ST) 0
Total payoff ST – X X – ST

The payoff structure of the short straddle is shown in Figure E.1,

with a dotted line f or the payoff “net” of the purchase prices of the
call and put options. Because both options are sold in this strategy,
the initial cash flow is positive and the dotted line is plotted above
the solid line. The short straddle yields a positive net profit as long as
the security stays close to the strike price. If the security moves away
f rom the strike price in either direction by more than the combined
option premiums, the short straddle shows a loss. The motivation for
this speculative strategy is a belief that the realized volatility of the
underlying security will not be as high as the volatility implied by the
option prices.
Figure E.1. Payoff Profile of a Short

Straddle
X1 – C – P X1 + C + P
C+P
0
X1
–X1
b. The bear put spread is constructed by buying a put option at a high strike
price, X 2, and selling a put option at a lower strike price, X1. The contin-
gency table follows.
ST < X 1 X 1 < ST < X 2 ST > X 2

Put option at X 2 X 2 – ST X 2 – ST 0
– Put option at X1 – (X1– ST) 0 0
Total payoff X 2 – X1 X 2 – ST 0
The payoff profile of the bear put spread is shown in Figure E.2. The
bear put spread yields a positive net payoff if the security price drops
below the breakeven point, which is the higher strike price, X 2 , minus

Exercises
the cost of establishing the spread. The cost of the spread is equal to the
price paid for the higher strike-price put, P2 , minus the price received
for the lower strike-price put, P1. By arbitrage, we know that P2 > P1,
so the cost is positive. In addition, we know that P2– P1 < X 2 – X1.
Otherwise, the dotted line would fall entirely below zero, which would
create an arbitrage opportunity for someone by reversing the positions
and generating a riskless return with no investment. The motivation for
this strategy is a bearish outlook for the security with limited potential
gains and losses.
Figure E.2. Payoff Profile of a Bear Put Spread
Breakeven Point:
X2 – (P2 – P1)
X2 – X1
X2
0
X1
c. The ratio spread or upside ratio spread is constructed by buying a call option
at a low strike price and selling two call options at a higher strike price.
The contingency table follows.
ST < X 1 X 1 < ST < X 2 ST > X 2

Call option at X1 0 ST – X 1 ST – X 1
– Two call options at X 2 0 0 –2(ST – X 2)
Total payoff 0 ST – X 1 2X 2 – X1 – ST
The payoff profile of the ratio spread is shown in Figure E.3. The net profit
is positive as long as the security price remains below the breakeven point,
which is above the higher strike price, although the largest net profit is
around the higher strike price. Beyond the breakeven point, the spread
loses $2.00 for every $1.00 increase in the security price; in other words,

the right-most part of the payoff profile is steeper (2 for 1 instead of 1 for
1) than it is f or many other option strategies. A “downside” ratio spread
is constructed by buying one put option and selling two others at a lower
strike price.
Figure E.3. Payoff Profile of a Ratio Spread
Breakeven Point:
2X2 – X1 + 2C2 – C1
X2 – X1 + 2C2 – C1
2C2 – C1
0
X1 X2
d. A butterfly spread is constructed by buying two call options with separate

strike prices and selling two call options with a strike price between the
long call options. The contingency table follows.
ST < X 1 X 1 < ST < X 2 X 2 < ST < X 3 ST > X 3

Call option at X1 0 ST – X 1 ST – X 1 ST – X 1
Call option at X 3 0 0 0 ST – X 3
– Two call options at X 2 0 0 –2(ST – X 2) –2(ST – X 2)
Total payoff 0 ST – X 1 2X 2 – X1 – ST 2X 2 – X1 – X 3
The payof f prof ile for the butterf ly spread is shown in Figure E.4.
Because the strike prices are equally spaced in this example, the
gross payoff prof ile for high and low prices of the stock is zero. The
dotted line (net payoff ) must lie below the solid line (i.e., the cost of
the options purchased exceeds the cost of the options sold) or there
would be an arbitrage opportunity. Similar to the short straddle, the
motivation for the butterf ly spread is the belief that the underlying
security is going to have lower realized volatility than the volatility
implied by the option prices. In contrast to the short straddle, the
Exercises
downside risk of the butterf ly spread is limited. This strategy results

in negative net profits as the security price moves beyond the outside
strike prices.
Figure E.4. Payoff Profile of a Butterfly Spread
X2 – X1
0
X1 X2 X3
Breakeven Point:
X3 – (C1 + C3 – 2C2)
Breakeven Point:
X1 + (C1 + C3 – 2C2)
e. A condor is constructed by selling two call options with separate strike

prices near the money and buying two additional call options with strike
prices outside the two short positions. The condor is similar to the butter-
fly spread except that the two short positions have different strike prices.
The contingency table follows.
ST < X 1 X 1 < ST < X 2 X 2 < ST < X 3 X 3 < ST < X4 ST > X4
Call option at X1 0 ST – X 1 ST – X 1 ST – X 1 ST – X 1
– Call option at X 2 0 0 –(ST – X 2) –(ST – X 2) –(ST – X 2)
– Call option at X 3 0 0 0 –(ST – X 3) –(ST – X 3)
Call option at X4 0 0 0 0 ST – X4
X3 + X2 X3 + X2
Total payoff 0 ST – X 1 X 2 – X1 –ST – X1 –X4 – X1 = 0
The payoff profile for the condor is shown in Figure E.5. If the outside
pairs of strike prices are equally spaced, the gross payoff profile for high
and low prices of the stock is zero. The dotted line (net payoff) must lie
below the solid line (the cost of the options purchased exceeds the cost of
the options sold) or there would be an arbitrage opportunity. Similar to
Figure E.5. Payoff Profile of a Condor
X2 – X1
0
X1 X2 X3 X4
C2 + C3 – C1 – C4
Breakeven Point:
X4 + C2 + C3 – C1 – C4
Breakeven Point:
X1 – C2 – C3 + C1 + C4
the short straddle and butterfly spread, the motivation for the condor is
the belief that the underlying security is going to have less realized vola-
tility than the volatility implied by the option prices.
f. The box spread is really a spread of two spreads—constructed by buying
a bull call spread and selling a bull put spread. The pair of option strike
prices for the put and call spreads are the same, with X 2 greater than X1.
The box spread can also be thought of as two put–call parity pairs, one
long and the other short. The contingency table follows.
ST < X 1 X 1 < ST < X 2 ST > X 2

Call option at X1 0 ST – X 1 ST – X 1
– Call option at X 2 0 0 –(ST – X 2)
– Put option at X1 –(X1 – ST) 0 0
Put option at X 2 X 2 – ST X 2 – ST 0
Total payoff X 2 – X1 X 2 – X1 X 2 – X1
The payoff profile f or the box spread, shown in Figure E.6, is a con-
stant, X 2 – X1, the same no matter what happens to the security price.
Because the payoff is constant, the four options should be priced to give
a net payoff equal to the riskless interest rate by arbitrage. In fact, the
cost of the box spread, which is (C1 + P2) – (C2 + P1), is equal to the pres-
ent value of the difference in strike prices at the riskless rate: (X 2 – X1)/
(1 + r)T.

Exercises
Figure E.6. Payoff Profile of a Box Spread
X2 – X1
X2 – X1
+ (C2 + P1)
– (C1 + P2)
0
X1 X2
Option Pricing
Exercise 12
Consider a non-dividend-paying stock currently priced at S 0 = $100.
In the binomial pricing approach, the stock will either move up to a price
of Su = $115 or move down to a price of Sd = $90 at time T (e.g., T = 1.0).
Consider a call and put option with a strike price of X = $95. In this
exercise, in order to focus on arbitrage pricing and hedging relationships,
we will assume a risk-f ree interest rate of exactly zero (i.e., 0.00%) over
time T.
a. Calculate the fair (i.e., arbitrage-free) price of the call option.
b. Calculate the fair (i.e., arbitrage-free) price of the put option.
c. Using only the stock and a risk-free bond, create the same payoff as the
call option.
d. Although not stated previously, assume the actual probabilities of the
stock going up to Su = $115 or down to Sd = $95 are, respectively, 60%
and 40%, so the expected price of the stock is 0.60(115) + 0.40(90) =
$105, giving an expected return 5.0%. How would the fair price of the
call option change if the actual probabilities of the stock moving up or
down were 80% and 20% (i.e., an expected return of 10.0%)?
e. Suppose the spread of terminal stock prices was wider, at Su = $130 and Sd
= $80 (instead of Su = $115 and Sd = $90). How would this change affect
the fair price of the call option?

Solutions
a. The call option payoff if the stock goes up is
Cu = max ( Su − X , 0 )
= max (115 − 95, 0 )
= $20,
and if the stock goes down,
Cd = max ( S d − X , 0 )
= max ( 90 − 95, 0 )
= $0.
The hedge ratio for the call option is
C − Cd
hC = u
Su − Sd
20 − 0
=
115 − 90
= 0.80,
meaning that owning 0.80 shares of the stock will offset the risk of writing
(i.e., selling) the call option. Specifically, a portfolio that is long 0.80 shares
and short the call option will have a payoff of 0.80(115) – 20 = 0.80(90) – 0
= $72 no matter which way the stock goes. Given that the terminal value
is certain, the upf ront cost of the portfolio, 0.25(50) – C0 , must be equal
to the present value of $72, which with the zero interest rate assumption
is just $72. Solving for the cost of the call option in this arbitrage-based
equality, 0.80(100) – C0 = 72, gives C0 = $8.00. However, this calculation
can be done more directly with the “risk-neutral” probability value,
S0 (1 + r )T − Sd
q=
Su − S d
100(1) − 90
=
115 − 90
= 0.40,
and the call option pricing formula,

qCu + (1 − q )Cd
C0 =
(1 + r )T
0.40(20) + 0.60(0)
=
1
= 8.00.

Exercises
Note that the expected stock price when the risk-neutral probabilities are
used is 0.40(115) + 0.60(90) = 100, so the expected return with these risk-
neutral probabilities is zero, the risk-free rate in this exercise.
b. The put option payoff if the stock goes up is
Pu = max ( X − Su , 0 )
= max ( 95 − 115, 0 )
= $0,
and if the stock goes down,
Pd = max ( X − Sd , 0 )
= max ( 95 − 90, 0 )
= $5.
The hedge ratio for the put option is
P − Pd
hP = u
Su − S d
0−5
=
115 − 90
= − 0.20,
which is the binomial model equivalent to the Black–Scholes delta (i.e.,

the delta of the call option was 0.80). Because of put–call parity, the delta
of the put is equal to the delta of the call option minus 1.0. Using the
risk-neutral probabilities, we find the price of the put option to be
qPu + (1 − q ) Pd
P0 =
(1 + r )T
0.40(0) + 0.60(5)
=
(1)
= 3.00.
The put price can also be verified, given the calculated call price, by the
put–call parity relationship:
X
P0 = C0 − S0 +
(1 + r )T
95
= 8 − 100 +
1
= 3.00.
c. The call option payoff of 20 or 0 can be replicated by borrowing $72 to

purchase hC = 0.80 shares at $100 per share. After paying off the $72 loan

(at zero interest), the total payoff will be 0.80(115) – 72 = 20 if the stock
goes up and 0.80(90) – 72 = 0 if the stock goes down.
d. The actual probabilities of the stock going up or down were never part
of the arbitrage-free pricing argument; only the hypothetical risk-neutral
probabilities were used. So, a change in the expected return, with the cur-
rent price of S0 = $100 held fixed, does not affect the price of the options.
e. The call option payoff if the stock goes up is now
Cu = max ( Su − X , 0 )
= max (130 − 95, 0 )
= $35,
but if the stock goes down,
Cd = max ( Sd − X , 0 )
= max ( 80 − 95, 0 )
= $0.
The hedge ratio for the call option is now

C − Cd
hC = u
Su − Sd
35 − 0
=
130 − 80
= 0.70,
meaning that owning 0.70 shares of the stock will offset the risk of writ-
ing (i.e., selling) the call option. The risk-neutral probability value is
S0 (1 + r )T − Sd
q=
Su − Sd
100(1) − 80
=
130 − 80
= 0.40,
and the call option pricing formula gives
qCu + (1 − q )Cd
C0 =
(1 + r )T
0.60(35) + 0.60(0)
=
(1)
= 14.00,

Exercises
which is higher than the previous price of 8.00 because of the higher vol-
atility (wider spread in stock prices) in the underlying security. Note that
using the put–call parity relationship gives the put price as
X 95
P0 = C0 − S0 + = 14.00 − 100 + = 9.00,
T 1
(1 + r )
which is also higher than the previous price of 3.00 because of the
increased volatility in the underlying security.
Exercise 13
Consider options on a non-dividend-paying stock and the f ollowing
Black–Scholes parameters: S0 = $82.40, X = $85.00, T = 0.25 (three months),
r = 2.00%, and= 34%.
a. Calculate the fair price of a European call option using the Black–Scholes
formula.
b. Calculate the fair price for a European put option using the Black–Scholes
formula.
c. Calculate the price of the call option with one week (T = 0.02), instead of
three months, to expiration if the stock price is still S0 = $82.40 and none
of the other parameters have changed.
d. Returning to the options with three months to expiration, approximately
how low would the stock price have to be for possible early exercise of an
American put option?
e. Suppose the quoted market price of the European call and put options in
Exercises 13a and 13b of this problem are, respectively, c0 = $5.50 and p0
= $7.50. Using an analytic formula, what is the volatility implied by these
prices? What is the exact implied volatility of the quoted call price when
the Black–Scholes formula is used?
Solutions
a. Referring to the cumulative normal probability values gives
 ln(82.40 / 85.00) + (0.02 + 0.342 / 2)(0.25) 

N (d1 ) = N  
 0.34 0.25 
= N ( −0.06833)
= 0.473
and

 ln(82.40 / 85.00) + (0.02 − 0.342 / 2)(0.25) 

N (d 2 ) = N  
 0.34 0.25 
= N ( −0.23833)
= 0.406.
The current price of the call option is, thus,
−0.02( 0.25 )
c0 = 82.40(0.473) − 85.00e (0.406)
= $4.63.
b. The price of the corresponding put option is
−0.02( 0.25 )
p0 = − 82.40(1 − 0.473) + 85.00e (1 − 0.406)
= $6.81.
c. Referring to the cumulative normal probability values gives
 ln(82.40 / 85.00) + (0.02 + 0.342 / 2) (0.02) 

N (d1 ) = N  
 0.34 0.02 
= N ( −0.61372 )
= 0.270
and
 ln(82.40 / 85.00) + (0.02 − 0.342 / 2)(0.02) 

N (d 2 ) = N  
 0.34 0.02 
= N ( −0.66181)
= 0.254.
The current price of the call option is, thus,
−0.02( 0.02 )
c0 = 82.40(0.270) − 85.00 e (0.254)
= $0.64,
which is quite low because the option is one week f rom expiring out of
the money.
d. The exercise value of the put option in Exercise 13b is 85.00 – 82.40 =
$2.60, well below the fair market price of $6.81. Recalculating the Black–
Scholes formula with the underlying stock price at $65 per share, how-
ever, gives a European put value of $19.91, below the exercise value at that
stock price of 85.00 – 65.00 = $20.00. So, early exercise at that price or

Exercises
lower might be preferred. Of course, if the put were American, early exer-
cise would have been anticipated by the market and built into the price.
For example, a numerical routine (not provided in this tutorial) gives a
fair American put price of $20.11 at the underlying stock price of $65, so
early exercise would not quite be preferred. According to the numerical
American put-pricing routine, the underlying stock price would have to
fall to about $61 or lower to be exercised early.
e. The approximate volatility implied by the quoted option prices is
C +P 2π
σ= 0 0
2 S0 T
5.50 + 7.50 2π
=
2 ( 82.40 ) 0.25
= 39.5,
which is higher than the assumed 34.0% volatility in this problem
because the quoted option prices are higher than the fair values calculated
in Exercises 13a and 13b. The exact implied volatility for the call option
based on the Black–Scholes f ormula (i.e., the volatility parameter that
results in a $5.50 call price) is 39.3%.
Exercise 14
Suppose a stock f ollows a two-period binomial process as shown in
Figure E.7. The stock price starts at $100 and can increase by $10 or f all
by $5 each period. At the end of the first period, the stock pays a dividend
of $4 and the ex-dividend price drops by that amount. Notice that the price
movements are absolute, not proportional, so the arbitrage-based hedge will
change over time as the stock price moves. Consider a call option with a
strike price of $100 (currently at the money) and an interest rate of 3.00%
per period.
a. Calculate the price of a European call option.
b. Incorporating the ex-dividend prices, calculate the price of an American
call option that can be exercised at Time 1, just before the dividend is paid.
Solution
a. Finding the value f or the call option requires finding the price of the
option at each stage by working backward f rom Time 2 to Time 1 to
Time 0. At Time 2, a call option with a strike price of $100 will have a
value of $16.00 or $1.00 or will expire out of the money with a value of

zero. If the stock price rises in the first period, the ex-dividend value of
the call option is given by using Equations 5.21 and 5.22:
Su (1 + r ) − Sud 106(1.03) − 101

qu = = = 0.545
Suu − Sud 116 − 101
and
qu Cuu + (1 − qu )Cud
Cu =
(1 + r )
(0.545)16 + (1 − 0.545)1
=
(1.03)
= 8.91.
If the stock price falls in the first period, the value of the ex-dividend call
option is given by
Sd (1 + r ) − Sdd 91(1.03) − 86
qd = = = 0.515
Sdu − Sdd 101 − 86
and
qd Cdu + (1 − qd )Cdd
Cd =
(1 + r )
(0.515)1 + (1 − 0.515)0
=
(1.03)
= 0.50.
Figure E.7. Two-Period Binomial Process
Time 0 Time 1 Time 1 Time 2

(ex-divided)
116
110 106
100 101
95
91
86

Exercises
Based on these results at Time 1, the value of the European call option at
Time 0 is given by
S0 (1 + r )T − Sd
q=
Su − S d
100(1.03) − 91
=
106 − 91
= 0.800
and
qCu + (1 − q )Cd
C0 =
(1 + r )T
(0.800)8.91 + (1 − 0.800)0.50
=
(1.03)
= 7.02.
b. If the stock rises in the first period, the pre-dividend exercise value of
the American call is 110 – 100 = $10, more than the value of $8.91
ex-dividend, so early exercise is optimal. If the stock price falls in the
first period, the option is out of the money, so early exercise would
be of no value, and in f act, it would be less than the $0.50 value ex-
dividend. Because the hedge is based on the ex-dividend stock price, q
is still 0.800 for the American call option, but the Time 0 value of the
American call is
qCu + (1 − q )Cd
C0 =
(1 + r )T
(0.800)10.00 + (1 − 0.800)0.50
=
(1.03)
= 7.86.
Thus, the ability to exercise early adds 7.86 – 7.02 = $0.84 to the value of
the American call option on this dividend-paying stock.
Option Sensitivities and Hedging

Exercise 15
Consider a put option with a delta of –0.289.
a. How many options per share would be required to create a delta-neutral
hedge for the underlying stock?

b. Instead of a delta-neutral hedge, suppose an investor wanted the hedged

stock to maintain a delta of 0.5. How many put options per share would
then be required?
c. Consider a call option with the same strike price and maturity as the
put option in this exercise. How many call options would be required to
maintain a hedged delta of 0.5?
d. Using both the put and call option in this exercise, how would an investor
create a delta-neutral and vega-neutral hedge on a share of the underlying
stock?
Solutions
a. The general hedging relationship given in Chapter 6 is
∆V − ∆1
h= ,
∆2
where ∆V is the desired hedge delta (i.e., zero for a delta-neutral hedge), ∆1 is
the delta of the underlying security (1.0 by definition), and ∆2 is the delta of
the option. So, in this case, the number of put options required per share is
∆V − ∆1
h=
∆2
0 − 1.0
=
−0.289
= 3.46.
b. If an investor wants to maintain a net delta of 0.5, the number of put
options required is
∆ − ∆1
h= V
∆2
0.5 − 1.0
=
−0.289
= 1.73.
c. The delta of the corresponding call option is 1 – 0.289 = 0.711, so the
number of call options required is
∆V − ∆1
h=
∆2
0.5 − 1.0
=
0.711
= −0.70,

Exercises
meaning that one would sell 0.70 call options to produce a delta of the
hedged stock position of 0.5.
d. Delta and vega neutrality require that the following two equations be sat-
isfied simultaneously:
∆ s + hc ∆ c + h p ∆ p = 0
and
ν s + hc ν c + h p ν p = 0.
The delta and vega of the underlying stock are 1 and 0 by definition.
Although we don’t know the vega f or these options, we do know that
they are positive and equal. We also know that the delta for the put is
equal to the delta for the call minus 1. With all these conditions, the only
possible solution to the two equations is to buy 1.0 put option and sell 1.0
call option. To see this conclusion, note that satisf ying the vega-neutral
condition requires that hC + hP = 0, resulting in the delta-neutral condi-
tion of hC = –1. Other nonunity solutions would be possible only by using
options with a different strike price for each option.
Exercise 16
Table E.1 gives sensitivity measures for various put and call options using
the Black–Scholes model, with S0 = 100 (other parameters are T = 0.25, r =
1.00%, and = 50%.)
Using the values in Table E.1, calculate the price and net sensitivity mea-
sures for each of the following strategies.
a. Short straddle. Sell 100-strike call and 100-strike put.
b. Bear put spread. Sell 90-strike put and buy 110-strike put.
c. Butterfly spread. Buy 90-strike call and 110-strike call; sell two 100-strike
calls.
Table E.1. Option Prices and Sensitivities

Call at X = 90 15.411 0.711 0.014 –0.045 0.139 0.171
Call at X = 100 10.061 0.554 0.016 –0.053 0.113 0.198
Call at X = 110 6.275 0.403 0.015 –0.052 0.085 0.194
Put at X = 90 5.186 –0.289 0.014 –0.043 – 0.085 0.171
Put at X = 100 9.811 –0.446 0.016 –0.050 –0.136 0.198
Put at X = 110 16.000 –0.597 0.015 –0.049 –0.189 0.194

d. Box spread. Buy 90-strike call, sell 110-strike call, sell 90-strike put, and
buy 110-strike put.
Solutions
The price and sensitivity measures f or a combination of options can be
calculated by summing the respective measures of each individual position,
with a negative sign for options that are sold. For example, the net delta of the
short straddle is –(0.554 – 0.446) = –0.108. The solutions for all parts of this
exercise are shown in Table E.2.
Note that the short straddle has little sensitivity to changes in the under-
lying stock price, as measured by delta, but has a large negative sensitivity to
changes in the volatility of the underlying stock, as measured by vega. The bear
put spread, however, has a large negative delta but smaller vega. Like the short
straddle, the butterfly has little delta—that is, it is directionally neutral—but
has a negative vega with respect to the volatility of the stock. Because of their
negative vegas, the short straddle and butterfly are sometimes referred to as short
volatility spreads. The box spread is, by design, delta, gamma, and vega neutral,
meaning that the spread price is insensitive to changes in underlying stock price
or volatility. In fact, the price of the box spread in this example is simply the pres-
ent value of 20, the difference in the strike prices of the constituent options. As a
present value, the price of the box spread does have sensitivities to time to expira-
tion, as measured by theta, and the risk-free interest rate, as measured by rho.
Table E.2. Option Spread Prices and Sensitivity Measures

Short
straddle –19.872 –0.108 –0.032 0.103 0.023 – 0.396
Bear put
spread 10.814 – 0.308 0.001 –0.006 –0.104 0.023
Butterfly
spread 1.564 0.006 –0.003 0.009 – 0.002 –0.031
Box spread 19.950 0.000 0.000 0.001 – 0.050 0.000
Synthetic Option Positions

Exercise 17
Using the put–call parity relationship, describe which combination of
securities creates each position synthetically:
a. Call option.

Exercises
b. Put option.
c. Riskless bond.
d. Covered call.
e. Protective put.
Solutions
The basic European put–call parity for a non-dividend-paying stock is
X
co − p0 = S0 − ,
(1 + r )T
which can be expressed in various ways to illustrate the creation of synthetic
positions.
a. The synthetic call can be created by borrowing the present value of X
while purchasing the security plus a put option with the same maturity
and exercise price:
X
co = p0 + S0 − .
(1 + r )T
b. The put option would be the equivalent of
X
po = c0 − S0 + ,
(1 + r )T
which indicates that shorting the security to purchase a call option of the
same maturity and strike price with the rest invested in a riskless bond
will mimic a put option.
c. The riskless bond would be the equivalent of
X
= po − c0 + S0 ,
(1 + r )T
so purchasing a security plus a put option and selling a call option with
the same maturity and strike price creates a synthetic bond.
d. A covered call would be the equivalent of
X
S0 − co = − p0 ,
(1 + r )T
so selling a put option and investing in a riskless bond gives the same
payoff as the covered call.

e. A protective put would be the equivalent of

X
S0 + po = + c0 ,
(1 + r )T
so purchasing a call and investing in a riskless bond gives the same payoff
as the protective put. This alternative combination is sometimes referred
to as a 90/10 strategy because about 90% of the portf olio is invested in
cash and 10% is spent on call options.

References
Current General References on Derivatives

Bodie, Zvi, Alex Kane, and Alan Marcus. 2011. Investments. 9th ed. New York:
McGraw-Hill Irwin.
Hull, John C. 2012. Options, Futures, and Other Derivatives. 8th ed. Upper Saddle
River, NJ: Prentice-Hall.
McDonald, Robert L. 2009. Derivative Markets. 3rd ed. London: Pearson.
Academic Papers on Derivatives after 1990
Bakshi, G., C. Cao, and Z. Chen. 1997. “Empirical Perf ormance of Alternative
Option Pricing Models.” Journal of Finance, vol. 52, no. 5 (December):2003–2049.
Brennan, M.J., and E.S. Schwartz. 1990. “Arbitrage in Stock Index Futures.” Journal
of Business, vol. 63, no. 1 (January):S7–S31.
Broadie, M., and J. Detemple. 1996. “American Option Valuation: New Bounds,
Approximations, and Comparison of Existing Methods.” Review of Financial Studies,
vol. 9, no. 4 (October):1211–1250.
Brown, G.W. 2001. “Managing Foreign Exchange Risk with Derivatives.” Journal of
Financial Econometrics, vol. 60, nos. 2–3 (May):401–448.
Coval, J.D., and T. Shumway. 2001. “Expected Option Returns.” Journal of Finance,
vol. 56, no. 3 (June):983–1009.
Figlewski, S., and B. Gao. 1999. “The Adaptive Mesh Model: A New Approach
to Efficient Option Pricing.” Journal of Financial Economics, vol. 53, no. 3
(September):313–351.
Grinblatt, M., and N. Jegadeesh. 1996. “The Relative Price of Eurodollar Futures
and Forward Contracts.” Journal of Finance, vol. 51, no. 4 (September):1499–1522.
Heath, D., R. Jarrow, and A. Merton. 1992. “Bond Pricing and the Term-Structure
of Interest Rates: A New Methodology for Contingent Claims Pricing.” Econometrica,
vol. 60, no. 1 (January):77–105.
Heston, S. 1993. “A Closed-Form Solution f or Options with Stochastic Volatility
with Applications to Bond and Currency Options.” Review of Financial Studies, vol.
6, no. 2 (April):327–343.
Hull, J.C., and A. White. 1995. “The Impact of Def ault Risk on the Prices of
Options and Other Derivative Securities.” Journal of Banking & Finance, vol. 19, no.
2 (May):299–322.
Rubinstein, Mark. 1994. “Implied Binomial Trees.” Journal of Finance, vol. 49, no. 3
(July):771–818.

General References on Futures

Arak, Marcelle, Laurie Goodman, and Susan Ross. 1986. “The Cheapest to
Deliver Bond on a Treasury Bond Futures Contract.” In Advances in Futures and
Options Research, 1, Part B. Edited by Frank Fabozzi. Oxford, United Kingdom:
JAI Press.
Black, Fischer. 1976. “The Pricing of Commodity Contracts.” Journal of Financial
Economics, vol. 3, nos. 1–2 (January/February):167–179.
Bookstaber, Richard M. 1985. The Complete Investment Book. Glenview, IL: Scott
Foresman Trade.
Chance, D. 1989. An Introduction to Options and Futures. Fort Worth, TX: Dryden
Press.
Hull, J. 1989. Options, Futures, and Other Derivative Securities. Boston: Prentice-Hall.
Johnson, L.L. 1960. “The Theory of Hedging and Speculation in Commodity
Futures Markets.” Review of Economic Studies, vol. 27, no. 3 (October):139–151.
Kolb, Robert W. 1982. Interest Rate Futures: A Comprehensive Introduction.
Richmond, VA: R.F. Dame.
———. 1985. Understanding Futures Markets. Glenview, IL: Scott Foresman Trade.
Kolb, Robert W., and Gerald D. Gay, eds. 1982. Interest Rate Futures: Concepts and
Issues. Richmond, VA: R.F. Dame.
Kolb, Robert W., Gerald D. Gay, and William C. Hunter. 1985. “Liquidity
Requirements for Financial Futures Hedges.” Financial Analysts Journal, vol. 41, no.
3 (May/June):60–68.
Powers, Mark J. 1984. Inside the Financial Futures Markets. 2nd ed. Hoboken, NJ:
John Wiley & Sons.
Schwarz, Edward W., Joanne M. Hill, and Thomas Schneeweis. 1986. Financial
Futures: Fundamentals, Strategies, and Applications. Homewood, IL: Business One
Irwin.
Sharpe, William F. 1985. Investments. 3rd ed. Boston: Prentice-Hall.
Siegel, Daniel R., and Diane F. Siegel. 1990. Futures Markets. Fort Worth, TX:
Dryden Press.
General References on Hedging
Ahadi, Hamid Z., Peter A. Sharp, and Carl H. Walther. 1986. “The Effectiveness of
Futures and Options in Hedging Currency Risk.” In Advances in Futures and Options
Research, 1, Part B. Edited by Frank Fabozzi. Oxford, United Kingdom: JAI Press.
Ederington, Louis H. 1979. “The Hedging Perf ormance of the New Futures
Market.” Journal of Finance, vol. 34, no. 1 (March):157–170.

References
Figlewski, Stephen. 1984. “Hedging Perf ormance and Basis Risk in Stock Index
Futures.” Journal of Finance, vol. 39, no. 3 (July):657–669.
———. 1986. Hedging with Financial Futures f or Institutional Investors. Pensacola,
FL: Ballinger Publishing Company.
Gay, Gerald D., Robert W. Kolb, and Raymond Chiang. 1983. “Interest Rate
Hedging: An Empirical Test of Alternative Strategies.” Journal of Financial Research,
vol. 6, no. 3 (Fall):187–197.
Hill, Joanne, and Thomas Schneeweis. 1981. “A Note on the Hedging
Effectiveness of Foreign Currency Futures.” Journal of Futures Markets, vol. 1, no. 4
(Winter):659–664.
Kolb, Robert W., and Raymond Chiang. 1981. “Improving Hedging Performance
Using Interest Rate Futures.” Financial Management, vol. 10, no. 4 (Fall):72–79.
Kolb, Robert W., and Gerald D. Gay, eds. 1982. “Risk Reduction Potential of
Financial Futures for Corporate Bond Positions.” In Interest Rate Futures: Contracts
and Issues. Richmond, VA: R.F. Dame.
Empirical Research on Forward and Futures Prices
Cornell, B., and M. Reinganum. 1981. “Forward and Futures Prices:
Evidence f rom Foreign Exchange Markets.” Journal of Finance, vol. 36, no. 5
(December):1035–1045.
French, K. 1983. “A Comparison of Futures and Forward Prices.” Journal of Financial
Economics, vol. 12, no. 3 (November):311–342.
Park, H.Y., and A.H. Chen. 1985. “Differences between Futures and Forward
Prices: A Further Investigation of Marking to Market Effects.” Journal of Futures
Markets, vol. 5, no. 1 (Spring):77–88.
Rendleman, R., and C. Carabini. 1979. “The Efficiency of the Treasury Bill Futures
Markets.” Journal of Finance, vol. 34, no. 4 (September):895–914.
The Theoretical Relationship between Forward and Futures Prices
Cox, J.C., J.E. Ingersoll, and S.A. Ross. 1981. “The Relation between
Forward Prices and Futures Prices.” Journal of Financial Economics, vol. 9, no. 4
(December):321–346.
Jarrow, R.A., and G.S. Oldfield. 1981. “Forward Contracts and Futures Contracts.”
Journal of Financial Economics, vol. 9, no. 4 (December):373–382.
Kane, E.J. 1980. “Market Incompleteness and Divergences between Forward and
Futures Interest Rates.” Journal of Finance, vol. 35, no. 2 (May):221–234.
Richard, S., and M. Sundaresan. 1981. “A Continuous Time Equilibrium Model of
Forward Prices and Futures Prices in a Multi-Good Economy.” Journal of Financial
Economics, vol. 9, no. 4 (December): 347–371.

General References on Options

Black, Fischer. 1975. “Fact and Fantasy in the Use of Options.” Financial Analysts
Journal, vol. 31, no. 4 (July/August):36–41, 61–72.
Black, Fischer, and Myron Scholes. 1973. “The Pricing of Options and Corporate
Liabilities.” Journal of Political Economy, vol. 81, no. 3 (May/June):637–659.
Bookstaber, Richard M. 1985. The Complete Investment Book. Glenview, IL: Scott
Foresman Trade.
———. 1991. Option Pricing and Investment Strategies. Bloomington, IN: Probus
Publishing Company.
Chance, D. 1989. An Introduction to Options and Futures. Fort Worth, TX: Dryden
Press.
Choie, K., and F. Novomestky. 1989. “Replication of Long-Term with Short-Term
Options.” Journal of Portfolio Management, vol. 15, no. 2 (Winter):17–19.
Cox, John C., and Mark Rubinstein. 1985. Options Markets. Boston: Prentice-Hall.
Dengler, W.H., and H.P. Becker. 1984. “19 Option Strategies and When to Use
Them.” Futures Magazine, vol. 13 (June): http://media.futuresmag.com/futuresmag/
historical/SiteCollectionDocuments/Guides_PDFs/19OptionsStrategies.pdf.
Figlewski, S., W. Silber, and M. Subrahmanyam, eds. 1990. Financial Options: From
Theory to Practice. Salomon Brothers Center for the Study of Financial Institutions.
Homewood, IL: Business One Irwin.
Hull, J. 1989. Options, Futures, and Other Derivative Securities. Prentice-Hall.
Jarrow, Robert, and Andrew Rudd. 1983. Option Pricing. Homewood, IL: Business
One Irwin.
McMillan, Lawrence G. 1986. Options as a Strategic Investment. 2nd ed. New York:
New York Institute of Finance.
Merton, Robert C. 1973a. “The Relationship between Put and Call Option Prices:
Comment.” Journal of Finance, vol. 28, no. 1 (March):183–184.
———. 1973b. “The Theory of Rational Option Pricing.” Bell Journal of Economics
and Management Science, vol. 4, no. 1 (Spring):141–183.
Ritchken, Peter. 1987. Options: Theory, Strategy, and Applications. Glenview, IL: Scott
Foresman Trade.
Sharpe, William F. 1985. Investments. 3rd ed. Boston: Prentice-Hall.
Stoll, Hans R. 1969. “The Relationship between Put and Call Option Prices.” Journal
of Finance, vol. 24, no. 5 (December):319–332.
Yates, James W., and Robert W. Kopprasch. 1980. “Writing Covered Call Options:
Profits and Risks.” Journal of Portfolio Management, vol. 7, no. 1 (Fall):74–80.

References
Black–Scholes Model and Extensions

Black, Fischer. 1988. “How to Use the Holes in Black–Scholes.” Journal of Applied
Corporate Finance, vol. 1, no. 4 (Winter):67–73.
Cox, John C., and Stephen A. Ross. 1976. “The Valuation of Options f or
Alternative Stochastic Processes.” Journal of Financial Economics, vol. 3, nos. 1–2
(March):145–166.
Cox, John C., and Mark Rubinstein. 1983. “A Survey of Alternative Option Pricing
Models.” In Option Pricing. Edited by Menachem Brenner. Lexington, MA: Heath.
Cox, John C., Stephen A. Ross, and Mark Rubinstein. 1979. “Option
Pricing: A Simplified Approach.” Journal of Financial Economics, vol. 7, no. 3
Geske, R. 1979. “The Valuation of Compound Options.” Journal of Financial
Economics, vol. 7, no. 1 (March):63–81.
Hull, J., and A. White. 1987. “The Pricing of Options on Assets with Stochastic
Volatilities.” Journal of Finance, vol. 42, no. 2 (June):281–300.
Merton, Robert C. 1976. “Option Pricing When Underlying Stock
Returns Are Discontinuous.” Journal of Financial Economics, vol. 3, nos. 1–2
(January–March):125–144.
Rubinstein, M. 1983. “Displaced Diffusion Option Pricing.” Journal of Finance, vol.
38, no. 1 (March):213–217.
Smith, Clifford W., Jr. 1976. “Option Pricing: A Review.” Journal of Financial
Economics, vol. 3, nos. 1–2 (January–March):3–51.
Binomial Models
Boyle, P.P. 1988. “A Lattice Framework f or Option Pricing with Two State
Variables.” Journal of Financial and Quantitative Analysis, vol. 23, no. 1 (March):1–12.
Cox, John C., Stephen A. Ross, and Mark Rubinstein. 1979. “Option
Pricing: A Simplified Approach.” Journal of Financial Economics, vol. 7, no. 3
Hsia, Chi-Cheng. 1983. “On Binomial Option Pricing.” Journal of Financial Research,
vol. 6, no. 1 (Spring):41–50.
Hull, J., and A. White. 1988. “The Use of the Control Variant Technique in
Option Pricing.” Journal of Financial and Quantitative Analysis, vol. 23, no. 3
Option Volatilities
Beckers, S. 1981. “Standard Deviations in Option Prices as Predictors of
Future Stock Price Variability.” Journal of Banking & Finance, vol. 5, no. 3

Bookstaber, Richard M., and Steven Pomerantz. 1989. “An Inf ormation-Based
Model of Market Volatility.” Financial Analysts Journal, vol. 45, no. 6 (November/
December):37–46.
Brenner, M., and M. Subrahmanyam. 1988. “A Simple Formula to Compute the
Implied Standard Deviation.” Financial Analysts Journal, vol. 44, no. 5 (September/
October):80–83.
Chiras, D.P., and S. Manaster. 1978. “The Inf ormation Content of Option Prices
and a Test of Market Efficiency.” Journal of Financial Economics, vol. 6, nos. 2–3
(June–September):213–234.
Whaley, Robert E. 1982. “Valuation of American Call Options on
Dividend-Paying Stocks: Empirical Tests.” Journal of Financial Economics, vol. 10,
no. 1 (March):29–58.
Pricing American Options and Other Approaches
Barone-Adesi, G., and R.E. Whaley. 1987. “Efficient Analytic Approximation of
American Option Values.” Journal of Finance, vol. 42, no. 2 (June):301–320.
Boyle, P.P. 1977. “Options: A Monte Carlo Approach.” Journal of Financial Economics,
vol. 4, no. 3 (May):323–338.
Brennan, M.J., and E.S. Schwartz. 1977. “The Valuation of American Put Options.”
Journal of Finance, vol. 32, no. 2 (May):449–462.
———. 1978. “Finite Difference Methods and Jump Processes Arising in the
Pricing of Contingent Claims: A Synthesis.” Journal of Financial and Quantitative
Analysis, vol. 13, no. 3 (September):461–474.
Courtadon, G. 1982. “A More Accurate Finite Difference Approximation f or the
Valuation of Options.” Journal of Financial and Quantitative Analysis, vol. 17, no. 5
(December):697–705.
Geske, Robert. 1979. “A Note on an Analytic Formula for Unprotected American
Call Options on Stocks with Known Dividends.” Journal of Financial Economics, vol.
7, no. 4 (December):375–380.
———. 1981. “Comments on Whaley’s Note.” Journal of Financial Economics, vol. 9,
no. 2 (June):213–215.
Geske, R., and H.E. Johnson. 1984. “The American Put Valued Analytically.”
Journal of Finance, vol. 39, no. 5 (December):1511–1524.
Hull, J., and A. White. 1990. “Valuing Derivative Securities Using the Explicit
Finite Difference Method.” Journal of Financial and Quantitative Analysis, vol. 25, no.
1 (March):87–100.
Johnson, H.E. 1983. “An Analytic Approximation to the American Put Price.”
Journal of Financial and Quantitative Analysis, vol. 18, no. 1 (March):141–148.

References
MacMillan, L.W. 1986. “Analytic Approximation for the American Put Option.” In
Advances in Futures and Options Research. Edited by Frank Fabozzi. Oxford, United
Kingdom: JAI Press.
Roll, Richard. 1977. “An Analytic Valuation Formula f or Unprotected American
Call Options on Stocks with Known Dividends.” Journal of Financial Economics, vol.
5, no. 2 (November):251–258.
Whaley, Robert E. 1981. “On the Valuation of American Call Options on Stocks
with Known Dividends.” Journal of Financial Economics, vol. 9, no. 2 (June):207–211.
———. 1982. “Valuation of American Call Options on Dividend Paying Stocks:
Empirical Tests.” Journal of Financial Economics, vol. 10, no. 1 (March):29–58.
Options on Futures
Brenner, M., G. Courtadon, and M. Subrahmanyam. 1985. “Options on the Spot
and Options on Futures.” Journal of Finance, vol. 40, no. 5 (December):1303–1317.
Ramaswamy, K., and S.M. Sundaresan. 1985. “The Valuation of Options on Futures
Contracts.” Journal of Finance, vol. 40, no. 5 (December):1319–1340.
Shastri, Kuldeep, and Kishore Tandon. 1986. “Options on Futures Contracts: A
Comparison of European and American Pricing Models.” Journal of Futures Markets,
vol. 6, no. 4 (Winter):593–618.
Whaley, Robert E. 1986. “Valuation of American Futures Options: Theory and
Tests.” Journal of Finance, vol. 41, no. 1 (March):127–150.
Wolf , A. 1982. “Fundamentals of Commodity Options on Futures.” Journal of
Futures Markets, vol. 2, no. 4 (Winter):391–408.
Options on Currencies
Biger, Naham, and John Hull. 1983. “The Valuation of Currency Options.” Financial
Management, vol. 12, no. 1 (Spring):24–28.
Bodurtha, J.N., and G.R. Courtadon. 1987. “Tests of an American Option
Pricing Model on the Foreign Currency Options Market.” Journal of Financial and
Quantitative Analysis, vol. 22, no. 2 (June):153–167.
Garman, M.B., and S.W. Kohlhagen. 1983. “Foreign Currency Option Values.”
Journal of International Money and Finance, vol. 2, no. 3 (December):231–237.
Grabbe, J.O. 1983. “The Pricing of Call and Put Options on Foreign Exchange.”
Journal of International Money and Finance, vol. 2, no. 3 (December):239–253.
Options on Bonds
Black, Fischer, Emanuel Derman, and William Toy. 1990. “A One-Factor Model
of Interest Rates and Its Application to Treasury Bond Options.” Financial Analysts
Journal, vol. 46, no. 1 (January/February):33–39.

Bookstaber, R., and J. McDonald. 1985. “A Generalized Option Valuation Model

for the Pricing of Bond Options.” Review of Futures Markets, vol. 4, no. 1:60–73.
Dattatreya, R., and F. Fabozzi. 1989. “A Simplified Model f or Valuing Debt
Options.” Journal of Portfolio Management, vol. 15, no. 3 (Spring):64–72.
Macaulay, Frederick Robertson. 1910. Money and Credit and the Price of Securities.
Boulder, CO: University of Colorado Press.
Option Pricing
Black, Fischer, and Myron Scholes. 1972. “The Valuation of Option Contracts and a
Test of Market Efficiency.” Journal of Finance, vol. 27, no. 2 (May):399–418.
Bodurtha, J.N., and G.R. Courtadon. 1987. “Tests of an American Option
Pricing Model on the Foreign Currency Options Market.” Journal of Financial and
Quantitative Analysis, vol. 22, no. 2 (June):153–168.
Chance, D.M. 1986. “Empirical Tests of the Pricing of Index Call Options.” In
Advances in Futures and Options Research. Edited by Frank Fabozzi. Oxford, United
Kingdom: JAI Press.
Chiras, D., and S. Manaster. 1978. “The Inf ormation Content of Option Prices
and a Test of Market Efficiency.” Journal of Financial Economics, vol. 6, nos. 2–3
Galai, D. 1977. “Tests of Market Efficiency and the Chicago Board Options
Exchange.” Journal of Business, vol. 50, no. 2 (April):167–197.
Klemkosky, R.C., and B.G. Resnick. 1979. “Put–Call Parity and Market Efficiency.”
Journal of Finance, vol. 34, no. 5 (December):1141–1155.
MacBeth, J.D., and L.J. Merville. 1979. “An Empirical Examination of the
Black–Scholes Call Option Pricing Model.” Journal of Finance, vol. 34, no. 5
(December):1173–1186.
Shastri, K., and K. Tandon. 1986a. “An Empirical Test of a Valuation Model f or
American Options on Futures Contracts.” Journal of Financial and Quantitative
Analysis, vol. 21, no. 4 (December):377–392.
———. 1986b. “Valuation of Foreign Currency Options: Some Empirical Tests.”
Journal of Financial and Quantitative Analysis, vol. 21, no. 2 (June):145–160.
Performance Evaluation of Options

Bookstaber, Richard M. 1986. “The Use of Options in Perf ormance Structuring:
Modeling Returns to Meet Investment Objectives.” In Controlling Interest Rate Risk:
New Techniques and Applications for Money Management. Edited by Robert B. Platt.
Hoboken, NJ: John Wiley & Sons.

References
Bookstaber, Richard M., and Roger Clarke. 1985. “Problems in Evaluating the
Perf ormance of Portf olios with Options.” Financial Analysts Journal, vol. 41, no. 1
(January/February):48–62.
Brooks, Robert, Haim Levy, and Jim Yoder. 1987. “Using Stochastic Dominance
to Evaluate the Performance of Portfolios with Options.” Financial Analysts Journal,
vol. 43, no. 2 (March/April):79–82.
Clarke, Roger. 1987. “Stochastic Dominance Properties of Option Strategies.”
In Advances in Futures and Options Research, 2. Edited by Frank Fabozzi. Oxf ord,
United Kingdom: JAI Press.
Slivka, Ronald T. 1980. “Risk and Return f or Option Investment Strategies.”
Financial Analysts Journal, vol. 36, no. 5 (September/October):67–73.

Glossary
American option. An option that can be exercised at any time during its life.
Anticipatory hedge. A long anticipatory hedge is initiated by buying futures

contracts to protect against a rise in the price of an asset that will need
to be purchased at a later date. A short anticipatory hedge is initiated by
selling futures contracts to protect against the decline in price of an asset
to be sold at a future date.
Arbitrage. A transaction based on the observation of the same or an equiva-
lent asset selling at two different prices. The transaction involves buying
the asset at the lower price and selling it at the higher price for a (theo-
retically) riskless profit.
At the money. As applied to an option for which the price of the underlying
stock or futures equals the exercise price; an at-the-money option is nei-
ther in the money nor out of the money.
Backwardation. A condition in financial markets in which the f orward or
futures price is less than the expected future spot price.
Bank discount rate. A rate quoted on short-term non-interest-bearing money
market securities. The rate represents the annualized percentage discount
from face value at the time the security is purchased.
Basis. The price difference between the underlying asset and the futures con-
tract, generally calculated as the cash price minus the f utures price. For
some futures, the basis may be calculated as the futures price minus the
cash price so that the basis is represented as a positive number.
Basis point. A unit of measure equal to one one-hundredth of 1%. Equivalent
numerical values are 0.01% and 0.0001. Basis points are sometimes ver-
bally referred to as “beps” or written as the acronym “bps.”
Bear put spread. An option strategy consisting of a long put and a short put
at a lower strike price with the same maturity.
Bear spread. An option or futures spread designed to profit in a bear market.
Beta. A measure of the responsiveness of a security or portfolio to the market
as a whole. The term is generally used in the context of equity securities.

Binomial pricing model. A model based on the assumption that at any point
in time, the price of the underlying asset or futures contract can change
to one of only two possible values.
Black model. A pricing model developed by Fischer Black f or a European
option on a forward contract.
Black–Scholes model. A pricing model developed by Fischer Black and
Myron Scholes for a European option on an asset or security.
Bond-equivalent yield. The annualized yield on a short-term instrument
adjusted so as to be comparable with the yield to maturity on coupon-
bearing securities, which are usually compounded semiannually.
Box spread. An option strategy composed of a long bull call spread and a
long bear put spread, with identical strike prices and time to expiration
for each spread.
Breakeven point. The security price (or prices) at which a particular option
strategy neither makes money nor loses money. It is generally calculated
at the expiration date of the options involved in the strategy.
Bull call spread. An option strategy consisting of a long call and a short call
at a higher exercise price, with the same maturity for both call options.
Bull spread. An option or futures spread designed to profit in a bull market.
Butterfly spread. An option transaction consisting of one long call at a par-
ticular exercise price, another otherwise identical long call at a higher
exercise price, and two otherwise identical short calls at an exercise price
between the other two.
Calendar spread. An option strategy consisting of the purchase of an option
with a given expiration and the sale of an otherwise identical option with
a different expiration. Also referred to as a horizontal spread.
Call option. An option that gives the holder the right to buy the underlying
security at a specific price for a certain, fixed period of time.
Carry (“cost of carry”). A term associated with financing a commodity or
cash security until it is sold or delivered. It can include storage, insurance,
and assay expenses but usually refers only to the financing costs on repos
(repurchase agreements), bank loans, or dealer loans used to purchase the
security or asset.
Cash-and-carry arbitrage. A theoretically riskless transaction of a long posi-
tion in the spot asset and a short position in the futures contract that is

Glossary
designed to be held until the f utures expire. Such a transaction should

earn the short-term riskless rate to eliminate any arbitrage profits.
Cash settlement. The f eature of certain f utures contracts or options that
allows delivery or exercise to be conducted with an exchange of cash
rather than the physical transfer of assets.
Certificate of deposit (CD). A time deposit, usually with a bank or savings
institution, that has a specific maturity, which is evidenced by a certificate.
Cheapest to deliver (CTD). The bond or note that, if delivered on the
Chicago Board of Trade’s Treasury bond or note contract, provides the
smallest difference between the invoice price and the cost of the bond or
note.
Clearinghouse. An agency or corporation connected with an exchange
through which all f utures contracts are reconciled, settled, guaranteed,
and later, either offset or f ulfilled through delivery of the commodity.
The clearinghouse is the mechanism through which financial settlement
is made.
Closing transaction. A trade that reduces an investor’s position. Closing buy
transactions reduce short positions, and closing sell transactions reduce
long positions.
Collar. An option strategy consisting of a long position in an underlying
security and a short call and a long put with equal expiration dates, where
the call has a higher strike price than the put.
Commodity Futures Trading Commission (CFTC). An independent fed-
eral regulatory agency charged and empowered under the Commodity
Futures Trading Commission Act of 1974 with regulation of f utures
trading and all futures options in all commodities. The CFTC’s responsi-
bilities include examining and approving all contracts before they may be
traded on the exchange floor.
Commodity pool. An investment arrangement in which individuals combine
their funds to trade futures contracts, with a large cash reserve set aside to
meet margin calls.
Commodity trading adviser (CTA). An individual who specializes in offer-
ing advice regarding the trading of futures contracts.
Condor. An option position consisting of two otherwise identical short call
positions at separate strike prices and two long call positions at strike
prices outside the strike prices of the two short positions.

Contango. A condition in financial markets in which the forward or futures

price is greater than the expected future spot price.
Continuously compounded return. A rate of return between two points in
time in which the asset price is assumed to grow or pay a return at a con-
tinuous rate.
Convergence. The narrowing of the basis as a f utures contract approaches
expiration.
Conversion f actor. An adjustment f actor applied to the settlement price
of the Chicago Board of Trade’s Treasury bond and note contracts that
gives the holder of the short position a choice of several bonds or notes to
deliver.
Convexity. A measure of the curvature of a bond’s price line as interest rates
change. Convexity is of ten used together with duration to approximate
the change in the price of a bond as its yield to maturity changes.
Coupon rate. The rate of interest stated on a bond to be paid to the purchaser
by the issuer of the bond. Interest payments on a bond are generally paid
semiannually and are equal to the coupon rate multiplied by the f ace
value, prorated for the payment period.
Covered call. A combination of a long position in an asset, futures contract,
or currency and a short position in a call option on that asset.
Covered interest arbitrage. The purchase of an instrument denominated in
a foreign currency and hedging of the resulting foreign exchange risk by
selling the proceeds of the investment forward for dollars in the interbank
market or going short in that currency in the futures market.
Cross-hedge. The hedging of cash market risk in one commodity or financial
instrument by initiating a position in a futures contract for a different but
related commodity or instrument. A cross-hedge is based on the prem-
ise that, although the two commodities or instruments are not the same,
their prices generally move together.
Current yield. The return on an asset calculated by dividing the annual cou-
pon payments by the current price of the asset. Accrued interest is typi-
cally omitted in the calculation.
Daily settlement. The process in a f utures market in which the daily price
changes are paid by the parties incurring losses to the parties making
profits.

Glossary
Deferred contracts. Futures contracts that call for delivery in the more dis-
tant months, as distinguished from nearby months.
Delivery. The tender and receipt of an actual financial instrument in settle-
ment of a futures contract or the transfer of ownership or control of the
underlying commodity or financial instrument under terms established
by the exchange. The possibility that delivery can occur causes cash and
futures prices to converge.
Delivery factor. See Conversion factor.
Delivery month. A calendar month during which delivery against a futures
contract can be made.
Delta. The ratio of the change in an option’s price to a given change in the
underlying asset or futures price.
Delta/gamma neutral. A hedge position constructed from a combination of
options, futures, and/or the underlying security that has both a net delta
and a net gamma of zero for the combined position.
Delta neutral. A hedge position constructed from a combination of options,
futures, and/or the underlying security that has a net delta of zero for the
combined position.
Dividend yield. The ratio of the dividend to the stock price.
Duration. A measure of the size and timing of a bond’s cash flows. Duration
reflects the weighted average maturity of the bond and indicates the sen-
sitivity of the bond’s price to a change in its yield to maturity.
DV01. Dollar value impact of a 1 bp change in the yield of a fixed-income
security or derivative. DV01 is closely related to the concept of duration.
Dynamic hedge. An investment strategy in which an asset is hedged by sell-
ing futures in such a manner that the position is adjusted frequently and
simulates the price movement of an option strategy.
Dynamic option replication. The replication of the payoff of an option that
is created by shifting funds appropriately between a risky asset and cash
as the risky asset’s price changes.
Early exercise. The exercise of an American option before its expiration date.
Effective annual rate. The annual rate of return of an investment if com-
pounding occurred annually. The calculation of the effective annual
rate allows f or comparison of investments with different compounding
frequencies.

Eurodollar. A dollar deposited in a European bank or a European branch of

an American bank.
European option. An option that can be exercised only as it expires.
Exercise. To invoke the right granted under the terms of the option’s contract
to purchase or sell the underlying security. Call option holders exercise to
buy the underlying security; put option holders exercise to sell the under-
lying security.
Exercise price. The price at which an option permits its owner to buy or sell
the underlying security, futures, or currency.
Expiration date. The date af ter which an option or f utures contract is no
longer effective.
Fair value. The value of an option or f utures contract as determined by an
arbitrage relationship.
Foreign exchange rate. The rate at which a given amount of one currency
converts to another currency.
Forward contract. A transaction in which two parties agree to the purchase or
sale of a commodity at some future time. In contrast to futures contracts,
the terms of forward contracts are often not standardized and the forward
contract is not transferable or tradable to another party. Settlement of the
gains and losses on forward contracts is usually not done on a daily basis
as with futures contracts.
Forward foreign exchange rate. The rate associated with the purchase or sale
of one currency for another currency on a specific deferred delivery date.
Forward interest rate. The rate implied by the relationship between
spot rates of different maturities.
Futures contract. A standardized agreement between a buyer and a seller to
purchase an asset or currency at a later date at a fixed price. In contrast to
a forward contract, the futures contract trades on a futures exchange and
is subject to a daily settlement procedure of gains and losses.
Futures market. A market in which contracts for the future delivery of com-
modities or financial instruments are traded. The term can refer to a spe-
cific exchange or the market in general.
Futures option. An option on a futures contract.
Gamma. The ratio of the change in the option’s delta for a given change in
the underlying asset or futures price.

Glossary
Hedge. A transaction in which an investor seeks to protect a current position

or anticipated position in one market (say, the spot market) by using an
opposite position in another (say, the option or futures market).
Hedge ratio. The ratio of options or futures to a spot position (or vice versa)
that achieves an objective, such as minimizing or reducing risk.
Historical volatility. The standard deviation of return on a security, futures,
or currency obtained by estimating it f rom historical data over a recent
time period.
Horizontal spread. See Calendar spread.
Implied repo (repurchase agreement) rate. The cost of financing a cash-and-
carry transaction that is implied by the relationship between the spot and
futures price.
Implied volatility. The standard deviation of return on the underlying secu-
rity obtained when the market price of an option equals the price obtained
when using an option-pricing model.
Initial margin. The amount each participant in the f utures market must
deposit to the participant’s margin account at the time a buy or sell order
is placed to open a position.
Interest rate parity. The relationship between the spot and forward foreign
exchange rates and the interest rates of two currencies.
In the money. A call (put) option in which the price of the asset, futures, or
foreign exchange rate exceeds (is less than) the exercise price.
Intrinsic value. For a call (put) option, the greater of zero or the difference
between the security (exercise) price and the exercise (security) price.
Inventory hedge. A long inventory hedge is initiated by purchasing f utures
contracts to protect against a rise in the price of an asset held in a short
position. A short inventory hedge is initiated by selling futures contracts
to protect against a fall in the price of an asset currently held in a long
position.
Kappa. See Vega.
Last trading day. The final day under exchange rules when trading may occur
in a given contract month. Contracts outstanding at the end of the last
trading day must be settled by delivery of the underlying commodity or
securities or by cash settlement.

Leverage. The ability to control a large dollar amount of a commodity or

cash instrument with a comparatively small amount of capital by using
borrowed funds.
LIBOR (London Interbank Offered Rate). The average interest rate with
which London banks borrow money f rom each other; it is quoted f or
various currencies and various time frames. For example, the one-month
U.S. dollar LIBOR is the average rate for borrowing or lending dollars
for one month among London banks.
Limit move. An occurrence in which the futures price hits the upper or lower
daily price limit set by the exchange.
Long. As an adjective, the term ref ers to a trader who has purchased an
option or futures contract or the cash commodity or financial instrument
and has not yet offset that position (e.g., “the buyer of a futures contract
has a long position”). As an adverb, the term means the action of a trader
taking a position in which the trader has bought option or f utures con-
tracts (or a cash commodity) without taking the offsetting action (e.g.,
“the buyer went long the futures contract”).
Macaulay duration. The present value weighted time to maturity of the cash
flows of a fixed-income security with fixed payments.
Maintenance margin. A sum, usually smaller than the initial margin, that
must be maintained on deposit while a position is outstanding. When an
account drops below the maintenance level, the broker issues a margin
call requesting that enough money be added to bring the account back up
to the initial margin level.
Margin. Money deposited by both buyers and sellers of futures contracts to
ensure performance of the terms of the contract.
Mark to market. See Daily settlement.
Maturity. The time in the future when financial contracts are due or expire.
Maximum price fluctuation. See Limit move.
Mean–variance comparison. A comparison of risk and return for an asset
that uses the mean and variance of returns. Risk–return charts often use
standard deviation, the square root of variance.
Minimum price fluctuation. The smallest allowable increment of price
movement in a given contract. It is also referred to as a minimum tick.
Minimum-variance hedge ratio. The ratio of f utures contracts f or a given
spot position that minimizes the variance of the profit from the hedge.

Glossary
Modified duration. A duration measure scaled by dividing the Macaulay

duration by 1 plus the interest rate f or the period of compounding.
Modified duration measures the impact of a change in yield, in contrast to
the original Macaulay duration, which measures the impact of a percent-
age change in yield. Macaulay duration is calculated by the average time
to maturity of a security’s cash flows, weighted by their present values.
Money market rate. The interest rate paid on money market instruments,
such as certificates of deposit. The rate is a simple interest rate usually
based on a 360-day year for the term of the deposit.
Naked position. An isolated long or short position in the cash or f utures
market that is not hedged, spread, or part of an arbitrage.
Nearby contract. The futures contract month trading for the most immediate
delivery, as distinguished from distant or deferred months.
Negative carry. The net cost incurred when the cost of financing is greater
than the yield on the asset being carried.
Net cost of carry (net carry). The net cost of financing, which is equal to the
cost of financing minus the yield on the asset being carried.
Offsetting order. A futures or option transaction that closes out a previously
established long or short position.
Open contract or position. A contract that has been initiated but has not
yet been liquidated or offset by subsequent sale or purchase or by going
through the delivery process.
Open interest. The number of f utures or option contracts that have been
established but not yet offset or exercised.
Open outcry. The auction system used in the trading pits on the floor of the
futures exchange. All bids and offers are made openly and loudly by pub-
lic and competitive outcry and hand signals in such manner as to be avail-
able to all members in the trading pit at the same time.
Option. A contract that gives the holder the right, or choice, to buy or sell an
asset for a fixed price on or before a specified date in the future.
Option clearing corporation. The issuer of all listed option contracts trading
on national option exchanges.
Option replication. Techniques used to replicate the payoff of an option,
including dynamic hedging, synthetic options, and a basket of other
options.

Option-sensitivity measure. The change in option price or characteristics

attributable to change in the price of the underlying security, interest
rates, volatility, or time to expiration. See Delta, Gamma, Rho, Vega, and
Theta.
Out of the money. A call (put) option in which the price of the asset, cur-
rency, or futures contract is less (greater) than the exercise price.
Overvalued. A condition in which a security, option, or futures is priced at
more than its fair value.
Payoff. The amount of money received f rom a transaction at the end of the
holding period.
Payoff matrix. See Value matrix.
Payoff profile. A graph of an option strategy payoff plotted with respect to
the ending security price.
Payout protection. The downward adjustment of the exercise price of an
option f ollowing a cash distribution f rom a security (e.g., ex-dividend
price decline on stocks).
Pit. A location on the floor of a f utures exchange designated f or trading a
specific contract or commodity.
Portfolio insurance. An investment strategy that uses combinations of secu-
rities, options, or futures and is designed to provide a minimum or floor
value of the portfolio at a f uture date. It is equivalent to the payoff of a
protective put on the portfolio.
Position limit. The maximum number of contracts that can be held as speci-
fied in federal regulations.
Positive carry. The net gain earned over time when the cost of financing is
less than the yield on the asset being financed.
Protective put. An investment strategy involving the use of a long position in
a put and an asset to provide a minimum selling price for the asset.
Pure-discount bond. A bond, such as a Treasury bill, that pays no coupon
and sells at a discount from face or par value.
Put–call futures parity. The relationship among the prices of puts, calls, and
futures on a security, commodity, or currency.
Put–call parity. The relationship between the prices of puts, calls, and the
underlying security, commodity, or currency.

Glossary
Put option. An option granting the holder the right to sell the underlying
security or currency at a certain price for a specified period of time.
Ratio spread. An option strategy in which the ratio of long to short positions
is different from 1.0.
Repo. See Repurchase agreement.
Repurchase agreement. A securities transaction in which an investor sells a
security and promises to purchase it back in a specified number of days at
a higher price reflecting the prevailing interest rate.
Reverse repo agreement. A securities transaction in which an investor buys a
security with the promise to sell it back in a specified number of days at a
lower price reflecting the prevailing interest rate and yield on the security.
Rho. The ratio of the change in an option price to a change in interest rates.
Riskless asset. A theoretical asset with a nominal return that is known with
certainty. The return on a short-term Treasury bill is often used as a proxy
for the riskless rate.
Risk premium. The additional return a risk-averse investor expects for assum-
ing risk. The risk premium is often measured as the difference in expected
return between the risky asset and a riskless asset, such as a Treasury bill.
Rolling. An action in which the investor closes current option or f utures
positions and opens other options or futures with different strike prices or
maturities on the same underlying security.
Securities and Exchange Commission (SEC). The U.S. f ederal agency
responsible for regulating the securities and option markets.
Settlement price. The price established by a clearinghouse at the close of the
trading session as the official price to be used in determining net gains
or losses, margin requirements, and the next day’s price limits. The term
settlement price is also often used as an approximate equivalent to the term
closing price.
Sharpe ratio. The ratio of an investment’s risk premium (expected return
above the riskless rate) to its volatility as measured by the standard devia-
tion of returns.
Short. As an adjective, the term is applied to a trader who has sold option or
futures contracts or the cash commodity and has not yet offset that posi-
tion (e.g., “the seller of a futures contract has a short position”). As a verb,
the term means the action of a trader taking a position in which he has

sold option or futures contracts or made a forward contract for sale of the
cash commodity or instrument (e.g., “he shorted the futures contract”).
Short straddle. An option transaction that involves a short position in a put
and a call with the same exercise price and expiration.
Simple interest rate. The interest rate used to calculate the interest payment
for a specific period of time prorated for the portion of a year the maturity
represents.
Spot. The characteristic of being available for immediate (or nearly immedi-
ate) delivery. An outgrowth of the phrase on the spot, spot usually refers
to a cash market price f or stocks or physical commodities available f or
immediate delivery.
Spot price. The price of an asset on the spot market.
Spread. An option or futures transaction consisting of a long position in one
contract and a short position in another, similar contract.
Stack hedge. A hedge constructed by using nearby contracts with the intent
to roll them over to deferred contracts when the hedge must be extended
in time.
Standard deviation. A measure of the dispersion of a random variable around
its mean. Standard deviation is the square root of the variance.
Stock index. An average of stock prices designed to measure the performance
of a portfolio of stocks selected on the basis of the defined characteristics
of the index.
Stock index futures. A futures contract on any underlying stock index.
Straddle. An option transaction that involves a long position in a put and a
call with the same exercise price and expiration.
Strangle. An option transaction that involves a long position in a call and
a put with the same expiration and for which the strike price of the call
exceeds that of the put.
Strike price. See Exercise price.
Strip hedge. A hedge constructed by using contracts of varied maturities that
match the timing of the exposures to be hedged.
Synthetic call. A combination of a long put option and a long asset, futures,
or currency that replicates the behavior of a call option.
Synthetic cash. A combination of a long asset, a short call option, and a long
put option that replicates the return on a riskless asset.

Glossary
Synthetic futures. A combination of a long call option and a short put option
that replicates the behavior of a long futures contract.
Synthetic put. A combination of a long call option and a short asset, cur-
rency, or futures that replicates the behavior of a put option.
Term structure of interest rates. The relationship between interest rates and
maturities of zero-coupon bonds.
Theta. The ratio of the change of an option price to a change in expiration
date.
Time value. The difference between an option’s price and its intrinsic value.
Time value decay. The erosion of an option’s time value as expiration
approaches.
Treasury bill. Short-term pure-discount bond issued by the U.S. government
with an original maturity of 91, 182, or 365 days.
Treasury bond. A coupon-bearing bond issued by the U. S. government with
an original maturity of at least 10 years.
Treasury note. A coupon-bearing bond issued by the U.S. government with
an original maturity of 1–10 years.
Treynor ratio. The ratio of an investment’s risk premium to its beta, in con-
trast to the Sharpe ratio, which uses standard deviation instead of beta.
Unbiased. The characteristic of a forecast in which the prediction equals the
actual outcome, on average, of a large number of predictions.
Undervalued. A condition in which a security, option, or futures contract is
priced at less than its fair value.
Underlying security. The security that an investor has the right to buy or sell
via the terms of the listed option or futures contract.
Value matrix. A matrix of values to show the payoff of an option strategy
above and below the relevant exercise prices of the options used. Also
called a payoff matrix.
Variance. A measure of the dispersion of a random variable around its mean;
it is equal to the square of the standard deviation.
Variation margin. Money added to or subtracted from a futures account that
reflects profits or losses accruing from the daily settlement.
Variation margin call. A demand for money issued by a brokerage house to
a customer to bring the equity in an account back up to the margin level.

Vega. The ratio of a change in an option price to a change in the volatility of

the underlying security. Sometimes referred to as kappa.
Volatility. A measure of the amount by which an underlying security is
expected to fluctuate in a given period of time. Volatility is generally mea-
sured by the annualized standard deviation of percentage price changes in
the security.
Write. To sell an option. The investor who sells is the writer.
Yield curve. A chart in which yield to maturity is plotted on the vertical axis
and the maturity of a fixed-income security is plotted on the horizontal
axis. It is similar to a term structure curve.
Yield to maturity. The internal rate of return of a debt instrument held to
maturity. Capital gains or losses are considered as well as coupon pay-
ments. Semiannual compounding is typically assumed for bonds in the
United States.
Zero-coupon bond. See Pure-discount bond.

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FUNDAMENTALS OF

FUTURES AND OPTIONS

Roger G. Clarke, Harindra de Silva, CFA, Steven Thorley, CFA

Ameritech Meiji Mutual Life Insurance Company

Senior Research Fellows

For more on upcoming Research Foundation

Harindra de Silva, CFA

Steven Thorley, CFA

The Research Foundation of CFA Institute is a

Neither the Research Foundation, CFA Institute, nor the publication’s

Abby Farson Pratt Cindy Maisannes

Harindra de Silva, CFA, is a portfolio manager at and president of Analytic

This publication qualifies for 5 CE credits under the guide-

©2013 The Research Foundation of CFA Institute  vii

Bud Haslett, CFA

viii ©2013 The Research Foundation of CFA Institute

©2013 The Research Foundation of CFA Institute  ix

Although forward agreements for agricultural commodities have been around

©2013 The Research Foundation of CFA Institute  1

The growth of derivatives created an incentive f or investors to better

2 ©2013 The Research Foundation of CFA Institute

Figure 1.1. Arbitrage Links

Put–Call Parity Futures

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4 ©2013 The Research Foundation of CFA Institute

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• same-day settlement of simultaneous trades,

6 ©2013 The Research Foundation of CFA Institute

and f utures or options written on a volatility index, such as CBOE Market

©2013 The Research Foundation of CFA Institute  7

8 ©2013 The Research Foundation of CFA Institute

A f utures contract provides an opportunity to commit now to purchase

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actively traded markets use f utures contracts, although a substantial forward

Table 2.1. Algebraic Notation for Futures Prices

Nearby futures price F01 F11 —

Deferred futures price F02 F12 F22

10 ©2013 The Research Foundation of CFA Institute

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Pricing a Generic Futures Contract

Table 2.3. Cash-and-Carry Arbitrage

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Equity Index Futures Pricing

14 ©2013 The Research Foundation of CFA Institute

Bond Futures Pricing

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Table 2.4. Futures Prices for T-Note Contracts on

16 ©2013 The Research Foundation of CFA Institute

©2013 The Research Foundation of CFA Institute  17

Eurodollar Futures Pricing

Table 2.5. Futures Prices for Eurodollars on Tuesday,

Currency Futures Pricing

18 ©2013 The Research Foundation of CFA Institute

To understand covered interest arbitrage, consider the two following invest-

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viii ©2013 The Research Foundation of CFA Institute

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Figure 1.1. Arbitrage Links

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4 ©2013 The Research Foundation of CFA Institute

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6 ©2013 The Research Foundation of CFA Institute

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8 ©2013 The Research Foundation of CFA Institute

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Table 2.1. Algebraic Notation for Futures Prices

10 ©2013 The Research Foundation of CFA Institute

©2013 The Research Foundation of CFA Institute 11

Table 2.3. Cash-and-Carry Arbitrage

12 ©2013 The Research Foundation of CFA Institute

©2013 The Research Foundation of CFA Institute 13

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Table 2.4. Futures Prices for T-Note Contracts on

16 ©2013 The Research Foundation of CFA Institute

©2013 The Research Foundation of CFA Institute 17

Table 2.5. Futures Prices for Eurodollars on Tuesday,

18 ©2013 The Research Foundation of CFA Institute

Table 2.6. Futures Prices for Australian Exchange Rates

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20 ©2013 The Research Foundation of CFA Institute

Figure 2.1. Futures Contract Basis and Calendar Spread

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22 ©2013 The Research Foundation of CFA Institute

Table 3.1 Futures Basis

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24 ©2013 The Research Foundation of CFA Institute

Table 3.2 Futures Basis Example

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26 ©2013 The Research Foundation of CFA Institute

Table 3.3 Synthetic Equity Using Futures Contracts

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Table 3.4 Synthetic Cash Using Futures Contracts

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Figure 3.1. Return Profiles for Hedged Portfolios

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Figure 3.2. Return Distribution for Hedged Portfolios

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Figure 3.3. Hedging Time Frame

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Figure 3.4. Stack vs. Strip Contract Positions

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36 ©2013 The Research Foundation of CFA Institute

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38 ©2013 The Research Foundation of CFA Institute

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40 ©2013 The Research Foundation of CFA Institute

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42 ©2013 The Research Foundation of CFA Institute

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Figure 4.1. Option Positions

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46 ©2013 The Research Foundation of CFA Institute

Figure 4.2. Option Price Components