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Options on Stock Indices

and Currencies
Chapter 15

1 C. Hull 2013
Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John

Index Options

The most popular indices underlying options


in the U.S. are

The S&P 100 Index (OEX and XEO)


The S&P 500 Index (SPX)
The Dow Jones Index times 0.01 (DJX)
The Nasdaq 100 Index (NDX)

Contracts are on 100 times index; they are


settled in cash; OEX is American; the XEO
and all other options are European.

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John2C. Hull
2013

Index Option Example


Consider

a call option on an index


with a strike price of 1260
Suppose 1 contract is exercised
when the index level is 1280
What is the payoff?

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John3C. Hull
2013

Using Index Options for Portfolio


Insurance
Suppose the value of the index is S0 and the strike
price is K
If a portfolio has a of 1.0, the portfolio insurance
is obtained by buying 1 put option contract on the
index for each 100S0 dollars held
If the is not 1.0, the portfolio manager buys
put options for each 100S0 dollars held
In both cases, K is chosen to give the appropriate
insurance level

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John4C. Hull
2013

Example 1
Portfolio

has a beta of 1.0


It is currently worth $500,000
The index currently stands at 1000
What trade is necessary to provide
insurance against the portfolio value
falling below $450,000?

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John5C. Hull
2013

Example 2
Portfolio

has a beta of 2.0


It is currently worth $500,000 and index
stands at 1000
The risk-free rate is 12% per annum
The dividend yield on both the portfolio
and the index is 4%
How many put option contracts should
be purchased for portfolio insurance?
Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John6C. Hull
2013

Calculating Relation Between Index Level


and Portfolio Value in 3 months
If

index rises to 1040, it provides a


40/1000 or 4% return in 3 months
Total return (incl. dividends)=5%
Excess return over risk-free rate=2%
Excess return for portfolio=4%
Increase in Portfolio Value=4+31=6%
Portfolio value=$530,000
Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John7C. Hull
2013

Determining the Strike Price (Table


15.2, page 336)

Value of Index in 3
months

Expected Portfolio Value


in 3 months ($)

1,080
1,040
1,000
960
920
880

570,000
530,000
490,000
450,000
410,000
370,000

An option with a strike price of 960 will provide protection


against a 10% decline in the portfolio value
Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John8C. Hull
2013

Currency Options
Currency options trade on the NASDAQ
OMX
There also exists an active over-the-counter
(OTC) market
Currency options are used by corporations
to buy insurance when they have an FX
exposure

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John9C. Hull
2013

Range Forward Contracts


Have the effect of ensuring that the exchange
rate paid or received will lie within a certain
range
When currency is to be paid it involves selling a
put with strike K1 and buying a call with strike K2

When currency is to be received it involves


buying a put with strike K1 and selling a call with
strike K2

Normally the price of the put equals the price of


the call
Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John10
C. Hull

2013

Range Forward Contract continued


Figure 15.1, page 338

Payoff

Payoff
Asset
Price
K1

Short
Position

K2

K1

K2

Long
Position

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John11
C. Hull
2013

Asset
Price

European Options on Stocks


with Known Dividend Yields
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 = q
2. The stock starts at price S0eqT and
provides no income
Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John12
C. Hull
2013

European Options on Stocks


Paying Dividend Yield
continued
We can value European options by
reducing the stock price to S0eqT and then
behaving as though there is no dividend

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John13
C. Hull
2013

Extension of Chapter 10 Results


(Equations 15.1 to 15.3)

Lower Bound for calls:

c max( S 0e

qT

Ke

rT

, 0)

Lower Bound for puts

p max( Ke

rT

S0e

qT

, 0)

Put Call Parity

c Ke rT p S 0 e qT
Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John14
C. Hull
2013

Extension of Chapter 13 Results


(Equations 15.4 and 15.5)

c S 0 e qT N ( d1 ) Ke rT N (d 2 )
p Ke rT N ( d 2 ) S 0 e qT N ( d1 )
ln( S 0 / K ) ( r q 2 / 2)T
where d1
T
ln( S 0 / K ) ( r q 2 / 2)T
d2
T

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John15
C. Hull
2013

Valuing European Index Options


We can use the formula for an option
on a stock paying a continuous
dividend yield
Set S0 = current index level
Set q = average dividend yield
expected during the life of the option

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John16
C. Hull
2013

Using Forward/Futures Index


Prices (equations 15.6 and 15.7, page 343)
F0 S 0 e ( r q )T so that :
c e rT [F0 N(d1 ) KN (d 2 )]
p e rT [ KN ( d 2 ) F0 N ( d 1 )]
ln( F0 / K ) 2T / 2
d1
T
d 2 d1 T
Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John17
C. Hull
2013

Implied Dividend Yields

From European calls and puts with the same strike


price and time to maturity
1 c p Ke rT
q ln
T
S0

These formulas allow term structures of dividend yields


to be
OTC European options are typically valued using the
forward prices (Estimates of q are not then required)
American options require the dividend yield term
structure

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John18
C. Hull
2013

Currency Options: The Foreign


Interest Rate
We

denote the foreign interest rate by rf

The

return measured in the domestic


currency from investing in the foreign
currency is rf times the value of the
investment
This shows that the foreign currency
provides a yield at rate rf
Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John19
C. Hull
2013

Valuing European Currency Options


We

can use the formula for an option


on a stock paying a continuous
dividend yield :
Set S0 = current exchange rate
Set q = r

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John20
C. Hull
2013

Formulas for European Currency


Options
(Equations 15.8 and 15.9 page 344)

c S0e

rf T

p Ke

rT

where

N ( d1 ) Ke rT N (d 2 )
N (d 2 ) S 0 e

d1
d2

rf T

N ( d1 )

ln( S 0 / K ) ( r r

2 / 2)T

ln( S 0 / K ) ( r r

2 / 2)T

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John21
C. Hull
2013

Using Forward/Futures Exchange


Rates
(Equations 15.10 and 15.11, page 345)

Using F0 S0 e

( r rf ) 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
Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John22
C. Hull
2013

The Binomial Model for American


Options

S0

S0u
u

(1

S0d
d

p)

f = e-rt[pfu+(1 p)fd ]
Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John23
C. Hull
2013

The Binomial Model


continued

ad
p
ud
ae

( r q ) t

ae

( r r f ) t

ue

d 1/ u

for indices
for currencies

Fundamentals of Futures and Options Markets, 8th Ed, Ch 15, Copyright John24
C. Hull
2013