28-11-2020

Futures Options and Options on

Stock Indices and Currencies

Sankarshan Basu
Professor of Finance
Indian Institute of Management Bangalore

Futures Options

Mechanics of Futures Options

• When a call futures option is exercised the
holder acquires
1. A long position in the futures
2. A cash amount equal to the excess of the futures
price over the strike price
• When a put futures option is exercised the
holder acquires
1. A short position in the futures
2. A cash amount equal to the excess of the strike
price over the futures price

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Futures Call Option – Example

• Suppose it is August 15 and an investor has one
September futures call option contract on copper
with a strike price of 240 cents per pound. One
futures contract is on 25,000 pounds of copper.
• Suppose that the futures price of copper for
delivery in September is currently 251 cents, and
at the close of trading on August 14 (the last
settlement) it was 250 cents.
• If the option is exercised, the investor receives
– A cash amount of 25,000*(250 - 240) cents = $2,500
– Plus a long position in a futures contract to buy
25,000 pounds of copper in September.

Futures Put Option – Example

• An investor has one December futures put
option on corn with a strike price of 400 cents
per bushel. One futures contract is on 5,000
bushels of corn.
• Suppose that the current futures price of corn for
delivery in December is 380, and the most recent
settlement price is 379 cents.
• If the option is exercised, the investor receives
– A cash amount of 5,000 x (400 - 379) cents = $1,050
– Plus a short position in a futures contract to sell 5,000
bushels of corn in December.
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Pricing using Binomial Tree

Suppose that a 1-month call option on futures has a

strike price of 29. Risk-free rate = 6%, Time = 1 month
u = 1.1, d = 0.933
Futures Price = $33
Option Price = $4
Futures price = $30
Option Price=?
Futures Price = $28
Option Price = $0

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Pricing using Binomial Tree

ƒ = [ p ƒu + (1 – p )ƒd ]e–rT
= 0.4*4*exp(-0.06*1/12) = 1.592

where p  1  d  (1  28 / 30) /(33 / 30  28 / 30)  0.4

ud

Futures Prices in a Risk-Neutral World

• The differential equation satisfied by a

derivative dependent on a futures price is
f 1  f 2

 σ F 2 2
 rf
t 2 F 2

• The futures price can therefore be treated like a

stock paying a dividend yield of r.

Black’s Model For Pricing

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

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Black’s Formula
• The formulas for European options on
futures are known as Black’s formulas

c  e  rT F0 N ( d1 )  K N ( d 2 )
p  e rT K N (  d 2 )  F0 N (  d1 )
ln( F0 / K )   2T / 2
where d1 
 T
ln( F0 / K )   2T / 2
d2   d1   T
 T

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Problem No. 1 (Binomial Model)

• A futures price is currently 50. At the end

of six months it will be either 56 or 46. The
risk-free interest rate is 6% per annum.
What is the value of a six-month European
call option with a strike price of 50?

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Problem No. 1 (Binomial Model)

(Explanation)
In this case
u  1.12 and d  0.92.
The probability of an up movement in a risk - neutral world is
1  0.92
 0.4
1.12  0.92
From risk - neutral valuation, the value of the call is
e 0.06*0.5 (0.4 * 6  0.6 * 0)
 2.33

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Problem No. 2 (BSOPM)

• Calculate the value of a five-month
European put futures option when the
futures price is $19, the strike price is $20,
the risk-free interest rate is 12% per
annum and the volatility of the futures
price is 20% per annum.

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Problem No. 2 (BSOPM) (Ans. &

Explanation)
In this case,
F0  19, K  20, r  0.12,  0.20, T  5 / 12  0.4167
ln(19 / 20)  (0.2 2 / 2)  0.4167
d1   0.3327
0.2 0.4167
d 2  d1  0.2 0.4167  0.4618
The price of the put option is
[20N (0.4618)  19N (0.3327)] e  0.12*0.4167
 $1.50

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Options on Stock Indices and

Currencies

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European Options on Stocks

Paying a Known Dividend Yield
• The payment of a dividend causes the stock price
to drop by the amount of the dividend.
• The payment of a dividend yield at rate q
therefore causes the growth rate in the stock
price to be less than it would otherwise be by an
amount q.
• With a dividend yield of q, the stock price grows
from So at time zero to ST at time T.
– In the absence of dividends it would grow from So at
time zero to STeqT at time T.
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European Options on Stocks

Paying a Known Dividend Yield – contd.
• We get the same probability distribution
for the stock price at time T in each of the
following cases:
1. The stock starts at price S0 and provides a
dividend yield at rate q.
2. The stock starts at price S0e–q T and provides
no income.
• We can value European options by
reducing the stock price to S0e–q T and then
behaving as though there is no dividend.
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Stock Option Pricing with a

Known Dividend Yield
c  S 0 e  qT N ( d 1 )  Ke  rT N ( d 2 )
p  Ke  rT N (  d 2 )  S 0 e  qT N (  d 1 )
ln( S 0 / K )  ( r  q   2 / 2 )T
where d1 
 T
ln( S / K )  ( r  q   2 / 2 )T
0
d2 
 T
 d1   T

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Pricing European Index Options

• We can use the formula for an option

on a stock paying a dividend yield
Set S0 = current index level
Set q = average dividend yield expected
during the life of the option

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Pricing European Currency Options

• A foreign currency is an asset that

provides a “dividend yield” equal to rf
• We can use the formula for an option
on a stock paying a dividend yield :
Set S0 = current exchange rate
Set q = rƒ

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Formulas for European Currency

Options using Spot Exchange Rates
 rf T
c  S0e N (d1 )  Ke  rT N (d 2 )
 rf T
p  Ke rT N (d 2 )  S 0 e N ( d1 )
ln( S0 / K )  (r  r f   2 / 2)T
where d1 
 T
ln( S 0 / K )  (r  r f   2 / 2)T
d2 
 T
 d1   T
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Formulas for European Currency

Options using Forward Exchange Rates

Using F 0  S 0 e ( r  r f )T

c  e  rT [ F0 N ( d1 )  KN ( d 2 )]
p  e  rT [ KN (  d 2 )  F0 N (  d1 )]
ln( F0 / K )   2T / 2
d1 
 T
d 2  d1   T

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Summary of Key Results

• We can treat stock indices and
currencies like a stock paying a
dividend yield of q
–For stock indices, q = average
dividend yield on the index over the
option life
–For currencies, q = rƒ

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Problem No. 1 (Stock index)

• Calculate the value of a three-month at-
the-money European call option on a stock
index when the index is at 250, the risk-
free interest rate is 10% per annum, the
volatility of the index is18% per annum,
and the dividend yield on the index is 3%
per annum.

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Problem No. 1 (Stock index)

(Explanation)
In this case,
S0  250, K  250, r  0.1,   0.18, T  0.25 and q  0.03
ln(250 / 250)  (0.10  0.03  0.182 / 2)  0.25
d1   0.2394
0.18 0.25
d 2  d1  0.18 0.25  0.1494
The price of the call is
250N (0.2394)e 0.03*0.25  250 N (0.1494)e 0.10*0.25
 250 * 0.5946e 0.03*0.25  250 * 0.5594e 0.10*0.25
 11.15

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Problem No. 2 (Currency)

• Calculate the value of an eight-month
European put option on a currency with a
strike price of 0.50. The current exchange
rate is 0.52, the volatility of the exchange
rate is 12%, the domestic risk-free interest
rate is 4% per annum, and the foreign risk-
free interest rate is 8% per annum.

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Problem No. 2 (Currency)

(Explanation)
In this case,
S0  0.52, K  0.50, r  0.04, rf  0.08,   0.12 and T  0.6667
ln(0.52 / 0.50)  (0.04  0.08  0.12 2 / 2)  0.6667
d1   0.1771
0.12 0.6667
d 2  d1  0.12 0.6667  0.0791
The price of the put is
0.50 N (0.0791)e 0.04*0.6667  0.52 N (0.1771)e 0.08*0.6667
 0.50 * 0.4685e 0.04*0.6667  0.520.4297e 0.08*0.6667
 0.0162

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