Options and Futures

Futures contracts are an obligation

Must deliver or offset
Liable for margin calls
Locked into a price

Options on futures contracts are the right to take a position in the
futures market at a given price called the strike price, but beyond
the initial premium, the option holder has no obligation to act on the
contract
Lock-in a price but can still participate in the market if prices
move favorably
No margin calls
Pay a premium for the option (similar to price insurance)

Put and Call Options
Put option: the right to sell a futures contract at a given
price
Call option: the right to buy a futures contract at a given
price
Call and put options are separate contracts and not
opposite sides of the same transaction. They are linked
to the Futures

Put Option
Buyer
Seller
Call Option Buyer Seller
Buyer
Futures
Seller
What can one do with an option
once you buy it

Let it expire
Lose the premium that was paid

Offset it: If one April Long Call is purchased then can
offset by selling one April Short Call

Exercise it (places in a short position (put) or a long
position (call) in the futures market. The holder then has
the same obligations as if a futures contract had
originally been bought or sold)
Strike Price Relationship to Current
Futures Price
Condition Put Option Call Option
SP < futures Out-of-the money In-the money
SP = futures At-the money At-the money
SP > futures In-the money Out-of-the money
History of Binomial Options
Pricing
The binomial options pricing model was developed by Cox, Ross,
and Rubenstein in 1979 and has subsequently been used
throughout the marketplace to price financial derivatives.
Instead of treating the underlying as if it follows a log normal
distribution like the Black-Scholes model, the binomial pricing model
assumes the stock price follows a simple binomial process broken
into discrete time steps.
Thus instead of a continuous distribution of stock prices, the stock is
considered to undergo a particular percentage change, up or down,
at each time step.
Pricing is then accomplished using the no-arbitrage assumption and
the creation of a risk-free portfolio that replicates option prices by
using the theoretical combination of stocks and risk-free bonds.

Assumptions of the BOPM

There are two (and only two) possible prices for the underlying
asset on the next date. The underlying price will either:

Increase by a factor of u% (an uptick)
Decrease by a factor of d% (a downtick)

The uncertainty is that we do not know which of the two prices
will be realized.

No dividends.

The one-period interest rate, r, is constant over the life of the
option (r% per period).

Markets are perfect (no commissions, bid-ask spreads, taxes,
price pressure, etc.)
Replicating Portfolio
P= $100
X= $125
T= 1 year
i= 8%
Su= $200
Sd= $50
Stock Call
Option
Su= $200
Sd= $50
P= $100
Cu= max($0,
$200-
$125)=$75
Cd= max( $0,
$50-$125)= $0
C=??
Step 1: Construct Bankruptcy free portfolio
Stocks minimum value is $50
So, borrow $50 at PV = $50/1.08= $46.3
Therefore, you invest $53.70 of your own money
Step 2: Replicate future Returns
We want net returns from option to equal $0, or $150
Therefore, you have to buy 2 call options
Step 3: Align the dollar cost of option and the
portfolio
As dollar outlay of bankruptcy free portfolio is $53.70, this
should be same for two call option contracts
Step 4: Value the Option
Cost of one contract comes out to be
C = $53.7/2= $26.85



Using Hedge Ratio to develop Replicating
Portfolio
To eliminate the price variation through short sale of an asset
exhibiting the same price volatility as asset to be hedged.
Perfect hedge creates a riskless position
Hedge ratio indicates number of asset units needed to
eliminate price volatility of one call option
In previous example, a perfect hedge can be created by
selling one share short at $100 and buying two call options
Here no matter which way stock price moves, net value of hedged
portfolio will be $50
Therefore, PV of this strategy is $50/1.08= 46.3
C= 26.85
Hedge Ratio= (Cu-Cd)/(Su-Sd)
Synthetic Call Replication:
C= Hedge ratio X [Stock Price PV (borrowing)]

Risk Neutral Valuation
One step binomial model can also be expressed
in terms of probabilities and call prices
The sizes of upward and downward movements
are defined as functions of the volatility
U= size of up-move factor= e^(*sqrt t)
D= size of down move factor= 1/U
Risk Neutral probabilities

u
= (e

rt
D)/(U-D)

d =
1-
u
; r= continuously compounded annual risk free rate

Example
P = $20
= 14%
r = 4%
Dividends = Nil
Strike price = $20
Calculate the value of 1-year European call
option
U = e
0.14*1 =
1.15
D= 1/U= 0.87

u
= (e
0.04*1
D)/(U-D) = 0.61

d
= 1-0.61 = 0.39
Binomial tree for stock



Binomial Tree for Options

$20*1.15= $23
$20*0.87= $17.40
$20
$3= max(0, 23-20)
$0= max(0, 17.4-20)
Co
Expected value of option in one year is
calculated as:
Cu X
u
+ Cd X
d
($3*0.61) + ($0*0.39) = $1.83
Present Value = Co = $1.83/(e
0.04*1
)=
$1.76
To calculate value of put option, use put
call parity
Two Periods
Suppose two price changes are possible during
the life of the option
At each change point, the stock may go up by
R
u
% or down by R
d
%
Two-Period Stock Price
Dynamics
For example, suppose that in each of two
periods, a stocks price may rise by 3.25% or
fall by 2.5%
The stock is currently trading at $47
At the end of two periods it may be worth as
much as $50.10 or as little as $44.68
Two-Period Stock Price
Dynamics

$47
$48.53
$45.83
$50.10
$47.31
$44.68
Terminal Call Values

$C
0
$C
u
$C
d
C
uu
=$5.10
C
ud
=$2.31
C
dd
=$0
At expiration, a call with a strike
price of $45 will be worth:
Two Periods
The two-period Binomial model formula for a
European call is
C =
p
2
C
UU
+ 2p(1 p)C
UD
+ (1 p)
2
C
DD
1+ r ( )
2
P=47.1%
C=2.28
The n Period Binomial
Formula:
In general, the n-period model is:
. K] S d) (1 u) [(1 p) (1 p
j
n
r) (1
1
C
n
a j
n T
j n j j n j
n

=


+ +
|
|
.
|

\
|
+
=
Where a in the summation is the minimum number of
up-ticks so that the call finishes in-the-money.
Conclusion
Pricing by arbitrage is the main theory behind the binomial
pricing model.
In order to price an option, the model generates a portfolio of
stocks and risk-free bonds that exactly replicates the payoff of
the option.
For a stock that moves up or down a given amount in a
particular time step, a linear combination of stocks and risk-
free bonds can be put together in a portfolio that uniquely
represents this option price.
The uniqueness of this price is guaranteed by the arbitrage
theorem: if two assets or sets of assets have the same
payoffs, they must have the same market price.
Thus, we are given a procedure to determine the price of
options by dealing with portfolios that accurately replicate
their payoffs.