chapter 15
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Chapter 15. Other Derivative Assets. Outline. Futures options Pricing futures options Warrants Other derivative assets. Futures Options. Characteristics Speculating with futures options Spreading with futures options Basis risk with spreads Hedging with futures options - PowerPoint PPT PresentationTRANSCRIPT
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© 2004 South-Western Publishing 1
Chapter 15
Other Derivative Assets
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Outline
Futures options Pricing futures options Warrants Other derivative assets
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Futures Options
Characteristics Speculating with futures options Spreading with futures options Basis risk with spreads Hedging with futures options Speculators and hedging Early exercise of futures options
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Characteristics
Are futures options “uniquely worthless”? Futures options give users of the futures
market an enhanced ability to tailor their risk/return exposure to individual needs
Futures options provide an opportunity for the speculator to avoid the potentially unlimited losses associated with futures contracts
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Characteristics (cont’d)
Futures options are relatively new– Non-agricultural futures since 1982– Agricultural futures since 1984
Commodity Futures Trading Commission Act of 1974– Futures options must not be “contrary to the
public interest”– Futures options must serve legitimate hedging
purposes
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Characteristics (cont’d)
Futures options are no different from listed options– Futures calls give the right to go long– Call writer has the obligation to go short if the
call holder exercises– Futures puts give the right to go short– Put writer has the obligation to go long if the put
holder exercises
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Characteristics (cont’d)
The underlying security is the futures contract, not the physical commodity represented by the futures contract
The option holder decides if and when to exercise
Exercise of a futures call does not result in delivery of the underlying commodity
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Characteristics (cont’d)
Futures Prices
February 10, 2004
S&P 500 Index
Open High Low Settle Change
MAR 1138.30 1146.50 1137.60 1143.20 +330
JUN 1137.00 1145.00 1137.00 1142.30 +340
SEP …. …. …. 1141.40 +320
DEC 1139.00 1141.20 1139.00 1141.20 +350
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Characteristics (cont’d)
Futures Options Prices
February 10, 2004
S&P 500 Index
Calls Puts
Strike Price
FEB MAR APR FEB MAR APR
1140 11.60 22.50 30.20 8.40 19.30 27.90
1150 6.60 17.00 24.80 13.40 23.80 32.50
1160 3.30 12.60 20.00 20.10 29.40 37.60
1170 1.45 9.00 15.80 28.20 35.80 ….
1180 0.65 6.20 12.40 37.40 …. ….
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Characteristics (cont’d)
Like other puts and calls, futures options have both intrinsic value and time value
Expiration– The option month refers to the futures contract
delivery month– Depending on the commodity, the option may
expire on a specific date in the preceding month– The actual expiration date varies by commodity– Some futures options have a serial expiration
feature
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Speculating With Futures Options
Speculation principles for futures options are the same as for equity options
Buying futures options involves a predetermined, known, and limited maximum loss, just as with options on other assets– The option premium is the most the option
buyer can lose
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Speculating With Futures Options (cont’d)
Money At Risk Example
In early September, a speculator anticipates lower demand for soybeans and anticipates a drop in the price of soybeans. She decides to buy a put option on soybean futures. Specifically, she purchases 3 APR 8300 puts at a listed price of 25.25 cents. The money at risk is
3 contracts x 5,000bu/contract x $0.2525/bu = $3,787.50
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Spreading With Futures Options
Used by speculators in futures options to reduce their money at risk– E.g., construct a bullspread
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Spreading With Futures Options (cont’d)
Bullspread Example
Consider MAR 8600 and 8700 calls on soybeans with settlement prices of 7 cents and 5 cents per bushel, respectively. The table on the next slide shows the profit and loss summary for a soybean bullspread.
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Spreading With Futures Options (cont’d)
Bullspread ExampleFutures Settlement Price (cents per bushel)
858 860 862 864 866
Buy 8600 call @ $.07
-7 -7 -5 -3 -1
Write 8700 call @ $.05
+5 +5 +5 +5 +5
Net -2 -2 0 +2 +4
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Basis Risk With Spreads
If the basis of two futures contracts underlying a long position in futures options and a short position in futures options are different, it is possible that both contracts will move against you
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Hedging With Futures Options
There are as many ways to hedge with futures options as there are with equity or index options– Any hedge serves to limit risk with some
tradeoff in potential return– In the commodities market, there can be several
levels of hedging
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Hedging With Futures Options (cont’d)
Hedging Example
William Bob operates a 1,500-acre farm in the midwest and plans on harvesting 50,000 bushels of soybeans. To hedge price risk, Bob could go short 10 soybean contracts, covering 50,000 bushels. However, to protect himself against unexpected problems with the crop (such as tornadoes), Bob could hedge by only going short 9 soybean contracts. This reduces the inconvenience and cost of having to either close out some contracts at a financial loss or acquire soybeans in the cash market to deliver against the short contracts.
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Speculators and Hedging
Futures options are particularly useful to speculators of interest rate of stock index futures– If a speculator buys an S&P 500 index futures
contract, a market decline results in a reduced account balance as the contract is marked to market each day
– Puts on the S&P futures would provide some protection against the potentially large losses
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Early Exercise of Futures Options
Listed call options on equity securities or indexes will not normally be exercised early– This would result in an abandonment of the
remaining time value of the option
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Early Exercise of Futures Options (cont’d)
With futures options, there are circumstances in which it is optimal to exercise a call early– E.g., exercising a call allows the speculator to
go long in futures and to earn interest with the futures contract
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Pricing Futures Options
Futures option pricing model Disposing of valuable options Futures option deltas Implied volatility
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Futures Option Pricing Model
Black’s futures option pricing model for European call options:
Tab
T
TK
F
a
bKNaFNeC RT
and
2ln
where
)()(2
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Futures Option Pricing Model (cont’d)
Black’s futures option pricing model for European put options:
Alternatively, value the put option using put/call parity:
)()( aFNbKNeP RT
)( KFeCP RT
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Disposing of Valuable Options
The holder of a futures option has three alternatives:– Keep the option– Exercise the option– Sell the option
The risk of holding onto the option is that prices may move adversely
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Disposing of Valuable Options (cont’d)
The early exercise of option is normally suboptimal– Deep-in-the-money options have little time value
and it is often advantageous to exercise them early
Selling the option has the merit of capturing the remaining time value and converts the intrinsic value to cash
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Futures Option Deltas
Slightly different from delta for equity or index options– Call delta:
– Put delta:
)(aNe RT
)( bNe RT
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Implied Volatility
Implied volatility is the standard deviation of returns that will cause the pricing model to predict the actual option premium
Calculating implied volatility must be done via trial and error
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Warrants
Characteristics Pricing Hedging with stock warrants
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Characteristics
A warrant is a non-dividend-paying security giving its owner the right to buy a certain number of shares at a set price directly from the issuing company
Warrants are relatively rare– Traded on the New York Stock Exchange, the
American Stock Exchange, and Nasdaq
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Characteristics (cont’d)
Warrants are really long-term call options Warrants give the owners the right to
purchase a set number of shares of stock directly from the issuing company
There is a predetermined exercise price and expiration date
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Characteristics (cont’d)
Warrants pay no dividends and their owners have no voting rights– Investors like them because they provide
leverage and let them assume a bullish position with a low investment
Warrants can have very unusual exercise terms and conditions
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Characteristics (cont’d)
The vast majority of warrants are from small, relatively risky firms, often issued in conjunction with an IPO
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Pricing
Primary factor is the relationship between the price of the underlying common stock and the exercise price– When the stock price rises above the exercise
price, the warrant is in-the-money
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Pricing (cont’d)
Actual
Maximum warrant
Warrant value price Minimum
Price value
Exercise
price
Stock price
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Pricing (cont’d)
The theoretical maximum price of a warrant is equal to the stock price
The theoretical minimum value is the warrant’s intrinsic value
The gap between the market price of the warrant and its minimum value is largest when the stock price equals the exercise price
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Pricing (cont’d)
New York Stock Exchange Warrants
February 11, 2004
Issuer Symbol Exercise price
Expiration Warrant price
Stock price
Chiquita Brands
CQB $19.23 3-19-09 $8.00 $23.23
Collegiate Pacific
BOO $5.00 5-26-05 $5.15 $10.05
Image Ware Systems
IW $12.00 4-5-05 $0.05 $4.40
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Hedging With Stock Warrants
A warrant hedge is similar to covered call writing
Warrant hedging involves the warrant lender
An investor buys shares of stock and simultaneously sell short warrants on the same company– To short sell, investor borrows warrants
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Hedging With Stock Warrants (cont’d)
If the stock price is below the exercise price at warrant expiration, the warrants are worthless– Short seller owes lender nothing and keeps
short sale proceeds– Loss in value of the underlying stock is reduced
by warrant proceeds
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Hedging With Stock Warrants (cont’d)
Warrants are exercised if stock price rises– Investor must repay the lender the loan– Investor’s profit is limited to the exercise price
plus the proceeds from the short sale
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Other Derivative Assets
Foreign currency options When-issued stock
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Foreign Currency Options
Foreign currency options began trading in 1982
Commercial banks arrange most currency option trading
Contracts guaranteed by Options Clearing Corporation
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Foreign Currency Options (cont’d)
Different from options on foreign currency futures– Currency call gives you the right to buy the
foreign currency– Currency futures call gives you the right to go
long the futures contract
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Foreign Currency Options (cont’d)
A foreign currency call is equivalent to a dollar put on the currency
The contract size is one-half the size of the futures contract
Unlike futures, options must be paid in full or a significant margin posted
The Black-Scholes model does not work well with foreign currency options
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When-Issued Stock
The NYSE permits investors to trade shares of stock issued in conjunction with a stock split even before new shares are distributed to existing shareholders
Both the new shares and the old shares trade simultaneously
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When-Issued Stock (cont’d)
The old shares will go ex-distribution on the second business day before the date of record– Purchase after this date is a purchase with a due
bill for the additional shares– Holders of the due bill are entitled to the new
shares when they are issued