Option Wk3
Option Wk3
Chapter 1
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.1
A derivative is an instrument whose value depends on the values of other more basic underlying variables
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.2
Examples of Derivatives
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.3
1.4
Futures Contracts
A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price By contrast in a spot contract there is an agreement to buy or sell the asset immediately (or within a very short period of time)
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.5
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.6
Futures Price
The futures prices for a particular contract is the price at which you agree to buy or sell It is determined by supply and demand in the same way as a spot price
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.7
Electronic Trading
Traditionally futures contracts have been traded using the open outcry system where traders physically meet on the floor of the exchange Increasingly this is being replaced by electronic trading where a computer matches buyers and sellers
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.8
1.9
Terminology
The party that has agreed to buy has a long position The party that has agreed to sell has a short position
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.10
Example
January: an investor enters into a long futures contract on COMEX to buy 100 oz of gold @ $600 in April April: the price of gold $615 per oz What is the investors profit?
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.11
1.12
Source: Bank for International Settlements. Chart shows total principal amounts for OTC market and value of underlying assets for exchange market
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.13
Forward Contracts
Forward contracts are similar to futures except that they trade in the over-thecounter market Forward contracts are popular on currencies and interest rates
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.14
Foreign Exchange Quotes for GBP on July 14, 2006 (See page 5)
Bid 1.8360 1.8372 1.8400 1.8438 Offer 1.8364 1.8377 1.8405 1.8444
1.15
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
Options
A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.16
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.17
Intel Option Prices (Sept 12, 2006; Stock Price=19.56); See page 6
Calls Jan 2007 4.950 2.775 1.175 0.375 0.125 Puts Jan 2007 0.150 0.475 1.375 3.100 5.450
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.18
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.19
Options vs Futures/Forwards
A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.20
10
1.21
A US company will pay 10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract An investor owns 1,000 Microsoft shares currently worth $28 per share. A two-month put with a strike price of $27.50 costs $1. The investor decides to hedge by buying 10 contracts
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.22
11
Value of Microsoft Shares with and without Hedging (Fig 1.4, page 12)
40,000 Value of Holding ($)
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.23
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.24
12
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.25
1.26
13
1.27
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
1.28
14
1.29
1.30
15
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
3.31
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
3.32
16
Companies should focus on the main business they are in and take steps to minimize risks arising from interest rates, exchange rates, and other market variables
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
3.33
3.34
17
Futures Price
Spot Price
Time t1 t2 3.35
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
Basis Risk
Basis is the difference between spot & futures Basis risk arises because of the uncertainty about the basis when the hedge is closed out
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
3.36
18
Long Hedge
Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future purchase of an asset by entering into a long futures contract Cost of Asset=S2 (F2 F1) = F1 + Basis
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
3.37
Short Hedge
Suppose that F1 : Initial Futures Price F2 : Final Futures Price S2 : Final Asset Price You hedge the future sale of an asset by entering into a short futures contract Price Realized=S2+ (F1 F2) = F1 + Basis
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
3.38
19
Choice of Contract
Choose a delivery month that is as close as possible to, but later than, the end of the life of the hedge When there is no futures contract on the asset being hedged, choose the contract whose futures price is most highly correlated with the asset price. There are then 2 components to basis
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
3.39
3.40
20
To hedge the risk in a portfolio the number of contracts that should be shorted is P
F
where P is the value of the portfolio, is its beta, and F is the current value of one futures (=futures price times contract size)
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
3.41
3.42
21
Example
Futures price of S&P 500 is 1,000 Size of portfolio is $5 million Beta of portfolio is 1.5 One contract is on $250 times the index What position in futures contracts on the S&P 500 is necessary to hedge the portfolio?
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
3.43
Changing Beta
What position is necessary to reduce the beta of the portfolio to 0.75? What position is necessary to increase the beta of the portfolio to 2.0?
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
3.44
22
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
3.45
Futures Options
Chapter 16
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Global Edition. Copyright John C. Hull 2010
46
23
Background
The commodity Futures Trading Commission authorized the trading of options on futures on an experimental basis in 1982. Permanent trading wa approved in 1987. The popularity of the contract with investors has grown very fast.
Expiration Months
Futures options are referred to by the delivery month of the underlying futures contract---not by the expiration month of the option. Most futures options are American. The expiration date of a futures option contract is usually on, or a few days before, the earliest delivery date of the underlying futures contract.
24
A long position in the futures A cash amount equal to the excess of the futures price at previous settlement over the strike price
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
49
A short position in the futures A cash amount equal to the excess of the strike price over the futures price at previous settlement
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
50
25
The Payoffs
If the futures position is closed out immediately: Payoff from call = (previous Settlement price K)+(F previous settlement price F)=F-K Payoff from put = K F where F is futures price at time of exercise
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
51
1.
2. 3.
4.
26
1.
2. 3.
4.
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
54
27
The payoff from a European all option with the same strike price on the futures price of the asset is
Max (FT - K, 0), where FT is the futures price at the options maturity.
If the futures contract matures at the same time as the option, then FT = ST, and the two options are equivalent.
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
55
Put-Call Parity for European Futures Options (Equation 16.1, page 347)
Consider the following two portfolios: A. a European call futures option plus Ke-rT of cash B. a European put futures option plus long futures contract plus cash equal to F0e-rT
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
56
28
Put-Call Parity for European Futures Options (Equation 16.1, page 347)
FT > K Portfolio A Call futures option Ke-rT Total Portfolio B Put futures option Long futures F0e-rT Total FT K K FT 0 (FT F0 ) F0 FT FT =< K 0 K K K FT (FT F0 ) F0 K
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
57
Put-Call Parity for European Futures Options (Equation 16.1, page 347)
Since portfolio A and portfolio B worth the same at time T, they should worth the same today. The value of portfolio A today is c+Ke-rT The value of portfolio B today is p+F0 e-rT Hence c+Ke-rT=p+F0 e-rT or c+(K-F0)e-rT=p
29
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
59
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
60
30
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
61
-2
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
62
31
The riskless portfolio is: long 0.8 futures short 1 call option The value of the portfolio in 1 month is 1.6 The value of the portfolio today is 1.6e 0.06/12 = 1.592
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
63
64
32
F0
65
Generalization
(continued)
Consider the portfolio that is long futures and short 1 derivative F0u F0 u F0d F0 d The portfolio is riskless when
u fd F0 u F0 d
66
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
33
Generalization
(continued)
Value of the portfolio at time T is F0u F0 u Value of portfolio today is Hence = [F0u F0 u]e-rT
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
67
Generalization
(continued)
where
p=
1 d u d
68
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
34
Numerical Example
Consider previously example. u=33/30=1.1, d= 28/30=0.9333, 4=0.06, T=1/12, fu = 4, and fd = 0.
p= 1 0.9333 = 0 .4 1.1 0.9333
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
69
70
35
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
71
72
36
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
Blacks Model
Compare equations on p.28 and equations on p.29, one clue could be derived. The two sets of equations are identical when we set q = r. Fischer Black was the first to show that European futures options can be valued using equations on p.28 with q = r and S0 replaced by F0.
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
74
37
Blacks Model
The formulas for European options on futures are known as Blacks model
c = e rT [F0 N ( d 1 ) K N ( d 2 ) ] p = e rT [K N ( d 2 ) F0 N ( d 1 ) ] d1 = d2 = ln( F0 / K ) + 2 T / 2 T T = d1 T
75
where
ln( F0 / K ) 2 T / 2
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
76
38
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
77
d 2 = d1 T = 0.07216 0.25 4 / 12 = 0.07216 N ( d1 ) = 0.4712 N ( d 2 ) = 0.5288 p = e 0.094 / 12 (60 0.5288 60 0.4712 ) = 3.35
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
78
39
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
79
d 2 = d1 T = 0.3026 0.2 0.5 = 0.1611 c = e 0.050.5 (930 N (0.3026) 900 N (0.1611) ) = $44.19
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
80
40
81
82
41
Fundamentals of Futures and Options Markets, 7th Ed, Ch 16, Copyright John C. Hull 2010
83
84
42
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.85
Types of Options
A call is an option to buy A put is an option to sell A European option can be exercised only at the end of its life An American option can be exercised at any time
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.86
43
Option Positions
Long call Long put Short call Short put
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.87
Long Call
(Figure 8.1, Page 186)
Profit from buying one European call option: option price = $5, strike price = $100. 30 Profit ($) 20 10 70 0 -5 80 90 100 Terminal stock price ($) 110 120 130
8.88
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
44
Short Call
(Figure 8.3, page 188)
Profit from writing one European call option: option price = $5, strike price = $100 Profit ($) 5 0 -10 -20 -30
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.89
Long Put
(Figure 8.2, page 188)
Profit from buying a European put option: option price = $7, strike price = $70 30 Profit ($) 20 10 0 -7 40 50 60 70 80 Terminal stock price ($) 90 100
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.90
45
Short Put
(Figure 8.4, page 189)
Profit from writing a European put option: option price = $7, strike price = $70 Profit ($) 7 0 -10 -20 -30
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
40
50
60 70 80
8.91
Payoff K ST
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
46
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.93
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.94
47
Terminology
Moneyness : At-the-money option In-the-money option Out-of-the-money option
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.95
Terminology
(continued)
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.96
48
Suppose you own N options with a strike price of K : No adjustments are made to the option terms for cash dividends When there is an n-for-m stock split, the strike price is reduced to mK/n the no. of options is increased to nN/m Stock dividends are handled in a manner similar to stock splits
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.97
Consider a call option to buy 100 shares for $20/share How should terms be adjusted: for a 2-for-1 stock split? for a 5% stock dividend?
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.98
49
Market Makers
Most exchanges use market makers to facilitate options trading A market maker quotes both bid and ask prices when requested The market maker does not know whether the individual requesting the quotes wants to buy or sell
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.99
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.100
50
Warrants
Warrants are options that are issued (or written) by a corporation or a financial institution The number of warrants outstanding is determined by the size of the original issue & changes only when they are exercised or when they expire
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.101
Warrants
(continued)
Warrants are traded in the same way as stocks The issuer settles up with the holder when a warrant is exercised When call warrants are issued by a corporation on its own stock, exercise will lead to new treasury stock being issued
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.102
51
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.103
8.104
52
Convertible Bonds
Convertible bonds are regular bonds that can be exchanged for equity at certain times in the future according to a predetermined exchange ratio
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.105
Convertible Bonds
(continued)
Very often a convertible is callable The call provision is a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose
Fundamentals of Futures and Options Markets, 6th Edition, Copyright John C. Hull 2007
8.106
53