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PRICING OF FUTURES
AND OPTIONS CONTRACTS
The pricing of futures is based on arbitrage principles. In a cash and carry trade, an investor sells an
overpriced future, purchases the underlying asset at the borrowing rate, and thereby pockets an
arbitrage profit. In a reverse cash and carry trade, the investor buys an underpriced future, shorts
the underlying asset and invests the money, and thereby pockets an arbitrage profit. (See book for
details of this trade.) The equilibrium price at which there is no arbitrage is the theoretical futures
price.
Using arbitrage arguments, the equilibrium futures price can be determined based on the following
information: (1) the price of the asset in the cash market; (2) the cash yield earned on the asset until
the settlement date; (3) the interest rate for borrowing and lending until the settlement date. The
borrowing and lending rate is referred to as the financing cost.
Letting:
The term (r - y) is called the net financing cost (or cost of carry, or simply carry).
The theoretical futures price may sell at a premium to the cash market price or at a discount from the
cash market price.
At the delivery date, the futures price must be equal to the cash market price. As the delivery date
approaches, the futures price will converge to the cash market price.
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A Closer Look at the Theoretical Futures Price
The following common factors are some of the reasons for the deviation of the actual futures price
from the theoretical futures price:
(5) the deliverable asset and the settlement date may be unknown;
(6) the deliverable may be a basket of securities which may be difficult to track; and
(7) there are differences in the tax treatment of securities and futures contracts.
PRICING OF OPTIONS
The option price can be decomposed into two parts. (1) The intrinsic value is the options economic
value if it is exercised immediately. If there is no positive economic value that will result from
exercising immediately then the intrinsic value is zero. (2) The time premium is the amount by
which the option premium exceeds its intrinsic value.
Put-call parity is the relationship between the price of a call option and the price of a put option on
the same underlying instrument, with the same strike price and the same expiration date. The prices
of puts and calls can be shown to follow the following relation
28-2
Factors that Influence the Option Price
There are six factors that influence the option price: (1) the current price of the underlying asset; (2)
the strike or exercise price; (3) the time to expiration of the option; (4) the expected price volatility
of the underlying asset over the life of the option; (5) the short-term risk-free interest rate over the
life of the option; (6) the anticipated cash payments of the underlying asset over the life of the option
(such as dividends).
An increase in these factors has the following effects on the value of a call and put option.
Stock price +
Strike price +
Time to expiration + +
Volatility + +
Risk-free rate +
Dividends +
Call values are positively related to the price and expected volatility of the underlying asset, the time
until expiration, and the short-term interest rate. The value of a call option is negatively related to
increases in the strike price and the level of cash payments to the underlying asset.
Put values are positively related to the strike price, the time to expiration, the expected price
volatility of the underlying asset, and the level of anticipated cash payments to the underlying asset.
Put prices are negatively related to the value or price of the underlying asset and the short-term
riskless rate of interest.
Theoretical boundary conditions for the price of an option can be derived based on arbitrage
arguments. Boundary conditions can be tightened by using arbitrage arguments coupled with
certain assumptions about the cash distributions expected for the underlying asset. The most popular
option pricing model is the Black-Scholes model. The underlying principle is that the payoff of an
option can be replicated with a portfolio consisting of the underlying asset and borrowed funds.
To derive a one-period binomial option pricing model for a call option, we begin by constructing a
portfolio consisting of (1) a long position in a certain amount of the asset, and (2) a short call
position in the underlying asset. The book runs through detailed examples of how the hedge is done.
Below is another simplified example of a binomial option pricing scheme.
It is helpful to see a simple option value calculation and how its determinants affect value,
particularly as value relates to volatility. The following example can be used in class.
Assume that the current stock price S = $100, strike price X = $130, time period T = 1 year,
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borrowing rate R = 5%, and no transaction costs. For simplicity, assume that the variance of the
stock price moves 50 percent by maturity so that the spread of possible future share prices is [S u,
Sd] = [$150, $50]. At the strike price of $130, the option would be in the money only if the stock
goes up by 50 percent. The option payoffs are calculated as P = max [0, S X] where S is the
share price at maturity. If the payoff is negative, meaning X > S at maturity, the option would not
be exercised and so the payoff would be zero. The spread of possible option payoffs at maturity is
[(Pu = Su X), (Pd = Su X)] = [$20, $0]. Suppose than the issuer wants to hedge this risk of the
option being called against him. He must create a portfolio of stock and borrowing that replicates
the option payoff. Moreover, the hedge must be self-funding so that the purchase of the stock is
funded externally by the option premium and borrowing as opposed to the issuers own funds
(which would defeat the purpose of a hedge). Based on these conditions, the issuer must purchase
1/5 share of common stock at the current price of $20, which must be funded by $9.52 of
borrowing, and $10.48 of option premium.
These calculations assume that stock prices have a binomial distribution. Of course, stock prices
typically take a distribution and the shape of this distribution is determined by the stocks
volatility. The Black-Scholes option pricing formula takes this into account with a partial
differential equation. But the binomial assumption keeps the example simple. With this in mind,
the calculation of the above values requires three steps.
Step 1: How many shares of stock must be bought? This is determined by the hedge ratio, which
is the spread of the possible option payoffs divided by the spread of the possible share prices:
Pu Pd $20 $0 1
. The issuer must buy 1/5 share of stock at the current price of
Su Sd $150 $50 5
$100. This $20 purchase must be funded by borrowing and option premium.
Step 2: How much borrowing is required? The borrowing amount is the present value of the
difference between the option payoff and the payoff from the 1/5 share at maturity:
( Su ) Pu ( Sd ) Pd (1 / 5 x $150) $20 (1 / 5 x $50) $0
Borrowing $9.52.
(1 R) (1 R) (1 5%) (1 5%)
Note that the borrowing is independent of the stock price movement.
Step 3: What is the option premium? The option premium is the value of the synthetic portfolio:
Option Value = Stock Value Borrowing. Here, the option premium must be (1/5 x $100)
$9.52 = $10.48. The combined amount of borrowing ($9.52) and premium ($10.48) exactly funds
the issuers purchase of the 1/5 share of stock ($20).
The value of the option equals the stock price minus borrowing. By replicating an option payoff
from a synthetic portfolio of ordinary assets and liabilities, the issuer has hedged his exposure to
the option risk. If this hedge is continuously maintained, the issuer has zero risk and so it is
irrelevant whether the stock price goes up or down.
The synthetic portfolio value must equal the option value, lest there be a riskless arbitrage
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opportunity. Arbitrage is the simultaneous purchase and sale of securities that creates a riskless
profit. Much of finance theory rests on the principle that market participants will ruthlessly exploit
riskless arbitrage opportunities and so such opportunities are not sustainable. The possibility of
arbitrage leads to the most fundamental principle of financial theory, the Principle of Absence of
Arbitrage, which states that there is always a tradeoff between risk and reward because in the
longterm there are no unbounded riskless gains. The moment such opportunities are discovered,
they will be exploited until they cease to exist. Thus, this process drives the markets Law of One
Price. Arbitrage keeps prices of the same assets consistent in spite of the different ways in these
assets may be packaged.
In the option context, if the option price is mispriced, either higher or lower than the synthetic
portfolio, an investor can always lock in a riskless profit by either selling the overpriced option or
buying the underpriced option and hedging with the synthetic portfolio. We can prove this.
Assume a call option is mispriced one dollar higher than intrinsic value, i.e., $11.48. An issuer
could execute an arbitrage by selling the option at $11.48, borrowing $9.52 at a rate of 5 percent
and then using the $21 in hand to buy 1/5 share of stock at $20. One dollar remains, which is
invested at a risk-free 5 percent. At maturity, if the stock increases to $150, the call option is in
the money and she owes the holder $20 and the lender $10. This $30 liability is matched exactly
by the 1/5 share of a $150 stock. The investors profit is $1.05. Now, if the stock price decreases
to $50, the option is out of the money and she owes the holder nothing but still owes $10 to the
lender. This liability is matched by the 1/5 share of $50 stock. But her profit is still $1.05. By
selling the mispriced option and hedging the exposure, she creates a riskless profit opportunity.
Thus, the option value must equal the value of the replicating portfolio.
The variance of the stock price substantially affects option value. Assume that the stock price is
less risky and moves 35 percent rather than 50 percent. At the strike price of $130 and per the
above calculations, the option premium is $2.72. If the volatility is 75 percent, the option value
is now $22.86. The change in variance from 35 to 50 to 75 percent results in an increase in
option value from $2.72 to $10.48 to $22.86. Thus, increased volatility of the underlying asset
increases option value.
Binomial models may have limited applicability to the pricing of options on fixed-income securities.
The binomial model assumed that (1) the price of the security can take on any positive value with
some probability, (2) the short-term interest rate is constant over the life of the option, and (3) the
volatility of the price of the security is constant over the life of the option.
These assumptions are unreasonable for an option on a fixed-income security: (1) the price of a
fixed-income security cannot exceed the undiscounted value of the cash flow; (2) the price of an
interest rate option will change as interest rates change; (3) that the variance of prices is constant
over the life of the option is inappropriate because as a bond moves closer to maturity its price
volatility declines.
The most elaborate models that take the yield curve into consideration, and as a result eliminate
arbitrage opportunities, are called yield curve option pricing models or arbitrage free option
pricing models.
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28-6
ANSWERS TO QUESTIONS FOR CHAPTER 28
(Questions are in bold print followed by answers.)
1. Models for pricing futures and options are said to be based on arbitrage arguments.
a. What does arbitrage mean?
b. What is the investors incentive to engage in arbitrage?
a. Arbitrage means taking advantage of price differentials of the same asset in different markets,
e.g. a difference in the futures and cash price of a security.
b. The incentive for arbitrage is the possibility of a riskless return.
2. Suppose there is a financial Asset ABC, which is the underlying asset for a futures
contract with settlement six months from now. You know the following about this financial
asset and the futures contract:
1. In the cash market, ABC is selling for $80.
2. ABC pays $8 per year in two semiannual payments of $4, and the next semiannual
payment is due exactly six months from now.
3. The current six-month interest rate at which funds can be loaned or borrowed is
6%.
a. What is the theoretical (or equilibrium) futures price?
b. What action would you take if the futures price is $83?
c. What action would you take if the futures price is $76?
d. Suppose that ABC pays interest quarterly instead of semiannually. If you know that
you can reinvest any funds you receive three months from now at 1% for three
months, what would the theoretical futures price for six-month settlement be?
e. Suppose that the borrowing rate and lending rate are not equal. Instead, suppose
that the current six-month borrowing rate is 8% and the six-month lending rate is
6%. What are the boundaries for the theoretical futures price?
28-7
e. The boundary for the theoretical futures price is
F = P + P (rB - y) = $80 + $80(0.04 - 0.05) = $ 79.20, and
F = P + P (rL - y) = $80 + $80(0.03 - 0.05) = $ 78.40
3.
a. Explain why restrictions on short selling of stocks would cause the actual price of a
stock index futures contract to diverge from its theoretical price.
b. Explain why creating a portfolio of stocks in which the number of stocks is less than
the number of stocks in the index underlying a stock index futures contract would
result in an arbitrage that is not riskless.
a. The need to wait for an uptick may prevent all stocks in an index from being sold
simultaneously.
b. Building a portfolio with a number of stocks fewer than that of an index creates a tracking
risk. The price changes of these securities may not duplicate those of the index. Hence, true
arbitrage conditions do not exist, so any attempts to seek arbitrage advantages may be risky.
4. Why do the delivery options in a Treasury bond futures contract cause the actual futures
price to diverge from its theoretical price?
The fact that the sellers of T-bond futures have options on which bonds to deliver and when to do
so, creates uncertainty for the buyers, and thereby causes a divergence of actual from theoretical
prices.
5. Of course the futures are more expensive than the cash pricetheres positive carry.
Do you agree with this statement?
Disagree. If there is a positive carry, the futures price should be less than the cash price.
28-8
7. Suppose the option in the previous question is a put option rather than a call option.
a. What is the intrinsic value for this put option?
b. What is the time premium for this put option?
a. If the option is a put, its price is out of the money. Consequently, its intrinsic value is zero.
b. Since the put option still has positive value, the time premium must be $6.
8. You obtain the following price quotes for call options on Asset ABC. It is now December,
with the near contract maturing in one months time. Asset ABCs price is currently trading
at $50.
Glancing at the figures, you note that two of these quotes seem to violate some of the rules
you learned regarding options pricing.
a. What are these discrepancies?
b. How could you take advantage of the discrepancies? What is the minimum profit
you would realize by arbitraging based on these discrepancies?
28-9
if the option expires in-the-money (if the price of ABC is greater than $40), the intrinsic value
of the March 40 call will be equal to the intrinsic value of the June 40 but the latter will have
time value. So, as in the previous scenario, the gain is $0.50 plus the time value.
a. Disagree. The problem with using the capital asset pricing model and the discounted cash flow
method of valuation is that the risks associated with an option changes continuously. Thus,
option valuation instead uses the continuous hedging by holding the underlying assets and
borrowing funds as a synthetic substitute for the cash flow of an option.
b. Disagree. An increase in stock volatility may cause the option price to rise, since there will be
a greater chance that the stock price will be in the money and therefore have increased
theoretical value.
c. Disagree. All other factors unchanged, the price of a call option will decline if the asset's price
declines. However, if another factor that affects the option price changes such that it offsets the
adverse affect of a decline in the asset's price, the price of a call can rise. For example, if
expected volatility rises, the call option premium can rise.
10. Consider two options with the same expiration date and for the same underlying asset.
The two options differ only in the strike price. Option 1s strike price is greater than that of
Option 2.
a. If the two options are call options, which option will have a higher price?
b. If the two options are put options, which option will have a higher price?
a. The second option will have a higher price, since its strike price is lower than the other one
relative to the market price of the stock. The greater differential means that the intrinsic value
of the second option will be higher.
b. Again, the option with the greater difference between the strike price and the market price will
have the greater intrinsic value. In the case of a put the reply is that the option with the higher
strike price would have greater value assuming that the market price was below either strike
prices. Otherwise neither options would have any intrinsic value.
28-10
11. Consider two options with the same strike price and for the same underlying asset. The
two options differ only with respect to the time to expiration. Option A expires in three
months and Option B expires in six months.
a. If the two options are call options, which option will have the higher intrinsic value
(assuming the options are in the money)?
b. If the two options are call options, which option will have a higher time premium?
c. Would your answers to (a) and (b) be different if the option is a put rather than a
call?
a. The intrinsic value for both options will be the same if have the same strike price.
b. The six-months option will have the greater time premium since there is a longer time period
for the option to become in the money.
c. It will be the same as in (a) and (b).
12. In an option pricing model, what statistical measure is used as a measure of the price
volatility of the underlying asset?
In an option pricing model, the statistical measure for price volatility is the standard deviation or
variance of the underlying stock prices.
13. For an asset that does not make cash distributions over the life of an option, it does not
pay to exercise a call option prior to the expiration date. Why?
The absence of cash payments on the underlying asset may increase the attractiveness of the
option. Otherwise the underlying asset becomes more attractive than the option.
a. The investment required under Strategy 2 is the call option price plus the present value of $110
(strike price of $100 and dividend distribution of $10) discounted at a 10% interest rate. Since
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the present value is $100, the investment required is:
Call option price + $100
b.
i If Asset M's price at expiration is $120, then the call option would be exercised. The value of
the call option would be $20 (its intrinsic value). The bank account would have a value of
$110 (principal plus interest). Thus, the payoff for Strategy 2 would be:
($20 + $110) - (call option price paid + $100)
or $30 - call option price paid
For Strategy 1, the payoff would be $17 or ($120 - $103), plus the cash distribution amount
of $10, for a total of $27.
ii If Asset M's price at expiration is $103, the call option would be exercised. The intrinsic
value would be $3. The payoff for Strategy 2 would be:
($3 + $110) - (call option price paid + $100)
$13 - call option price paid
For Strategy 1 the payoff would be $0 ($103 - $103), plus the cash distribution amount of
$10, for a total of $10.
iii If Asset M's price at expiration is $100, the intrinsic value of the call option would be zero, so
the payoff for Strategy 2 would be:
($0 + $110) - (call option price paid + $100)
$10 - call option price paid
For Strategy 1 the payoff would be - $3 ($100 - $103), plus the $10 cash distribution,
yielding $7.
iv If Asset M's price at expiration is $80, the intrinsic value of the call option would be zero, so
the payoff for Strategy 2 would be:
($0 + $110) - (call option price paid + $100)
$10 - call option price paid
For Strategy 1 the payoff would be - $23 ($80 - $103), plus the $10 cash distribution,
yielding a total of - $13.
c. The relationship between the call price and the price of the underlying asset, the present value of
the strike price, and the present value of the cash distribution is illustrated by the theoretical
discussion in the first part of the solution to part (b) of the question.
The hedge ratio is the amount of asset purchased per call sold.
28-12
16.
a. Calculate the option value for a two-period European call option with the following
terms:
Current price of underlying asset = $100
Strike price = $10
One-period, risk-free rate = 5%
The stock price can either go up or down by 10% at the end of one period.
b. Recalculate the value for the option when the stock price can move either up or
down by 50% at the end of one period. Compare your answer with the calculated
value in part (a).
a. Information set:
(now) (expiration)
t = 0 t = 1 t = 2
121
110 99
100 90 81
(now) (expiration)
t = 0 t = 1 t = 2
1+r d Cuu u 1 r C ud
C d = +
u d 1+ r u d 1+ r
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1+ 0.05 0.90 111 1.10 1 0.05 89
C u = + = 100.47
1.10 0.90 1+ 0.05 1.10 0.90 1+ 0.05
1+r d C du u 1 r C dd
C d = +
u d 1+ r u d 1+ r
thus:
1+0.05 0.90 89 1.10 1 0.05 71
C d = + = 80.471
1.10 0.90 1+ 0.50 1.10 0.90 1+ 0.05
1+ r - d C u u - 1- r Cd
C=( ) +( )
u - d 1+ r u - d 1+ r
C = $90.92
You should point out to students that the intrinsic value for this call option is $90 ($100 minus
$10). Therefore, the time premium is only $0.92. This is because the call option is deep in the
money.
b. The information set is the same as in part (a), except now volatility is assumed to be 50%
(now (expiration)
t = 0 t = 1 t = 2
225
150 75
100 50 25
(now) (expiration)
t = 0 t = 1 t = 2
28-14
1+ r d C uu u 1 r Cud
C u =
u d 1+ r u d 1+ r
thus:
1+ 0.05 0.50 215 1.50 1 0.05 65
Cu = + = 140.48
1.50 0.50 1+ 0.05 1.50 0.50 1+ 0.05
1+r d C du u 1 r C dd
C d = +
u d 1+ r u d 1+ r
thus:
1+0.05 0.50 65 1.50 1 0.05 15
C d = + = 40.48
1.50 0.50 1+ 0.05 1.50 0.50 1+ 0.05
C = $90.93.
17. What is the problem encountered in applying the binomial pricing model to the pricing
of options on fixed-income securities?
Binominal pricing model does not consider yield curve changes. It thereby allows arbitrage, a
factor that does not satisfy put-call parity.
28-15