CHAPTER 13

Options on Futures
In this chapter, we discuss option on futures contracts. This
chapter is organized into:
1. Characteristics of Options on Physicals and Options
on Futures.
2. The Market for Options on Futures
3. Pricing of Options on Futures
4. Price Relationship Between Options on Physicals and
Options on Futures
5. Put-Call Parity for Options on Futures
6. Options on Futures and Synthetic Futures
7. Risk Management with Options on Futures

Chapter 13

Characteristics of Options on Physicals

and Options Futures
Recall from Chapter 12 that options are written for a prespecified amount of a pre-specified asset at a pre-specified
price that can be bought or sold at a pre-specified time
period.
Call Options
The buyer of a call option has the right but not the
obligation to purchase.
The seller of a call option has the obligation to sell.
Put Options.
The buyer of a put option has the right but not the
obligation to sell.
The seller of a put option has the obligation to purchase.

Chapter 13

Characteristics of Options on Physicals

and Options Futures
Prices of options on futures are closely related to prices of
options on the underlying good.
Call Option on Futures
Upon exercising a option on futures, the call owner:
Receives a long position in the underlying futures at the
settlement price prevailing at the time of exercise.
Receives a payment that equals the settlement price
minus the exercise price of the option on futures.

The call owner would not exercise if the futures settlement

price did not exceed the exercise price.
Upon exercise, the call seller:
Receives a short position in the underlying futures at the
settlement price prevailing at the time of exercise.
Pays the long trader the futures settlement price minus
the exercise price.

Chapter 13

Characteristics of Options on Physicals

and Options Futures
On February 1, a trader buys a call option on a MAR euro
futures contract with an exercise price of $0.44 per euro.
On February 15, the call owner decides to exercise the call
option. The futures settlement price is $.48. After gathering
all the information, the owner has:
Future settlement price
The exercise price
The euro futures maturing
Euro contract amount

= $.48
= $.44/euro
= March
= 125,000 euros

Upon exercise, the call owner:

Receives a long position in the MAR euro futures contract.
Receives a payment = F0 E
$.48 - .44 (125,000) = $5000

Upon exercise, the call seller:

Receives a short position in the euro futures.
Pay $5,000.

The traders can offset or hold their futures positions.

Chapter 13

Characteristics of Options on Physicals

and Options Futures
Put Option on Futures
Upon exercising a option on futures, the put owner:
Receives a short position in the underlying futures
contract at the settlement price prevailing at the time of
exercise.
Receives a payment that equals the exercise price minus
the futures settlement price.

The put owner would not exercise unless the exercise price
exceeded the futures settlement price.
Upon exercise, the put seller:
Receives a long position in the underlying futures
contract.
Pays the exercise price minus the settlement price.

Chapter 13

Characteristics of Options on Physicals

and Options Futures
On April 1, a trader buys a put option on a MAY wheat
futures contract. The exercise price is $2.40/bushel and
wheat contract is for 5,000 bushels. On April 4, the owner
of the call option decides to exercise. The futures
settlement price is $2.32/bushel.
Exercise price
Wheat contract
Futures settlement price
The wheat futures matures

= $2.40/bushel
= 5,000 bushels
= $2.32/bushel.
= May

Upon exercise, the put owner:

Receives a short position MAY Wheat futures contract.
Receives a payment = F0 E
$2.40-$2.32 (5,000) = $400

Upon exercise, the put seller:

Receives a long position MAY Wheat futures contract.
Pays $400.

The traders can offset or hold their futures positions.

Chapter 13

Characteristics of Options on Physicals

and Options Futures
The following table summarizes the option examples
discussed previously.

The overall profitability of the transactions depends upon

the original premium and the prices that become available
before expiration of the option.

Chapter 13

The Market of Options on Futures

Figure 13.1 presents some illustrative quotations for
options on futures.
Insert figure 13.1 here

Chapter 13

The Market of Options on Futures

Table 13.1 shows the trading volume for options on futures
by type of commodity in the fiscal year ending September
30, 1995.

Chapter 13

The Market of Options on Futures

Chapter 13

10

The Market of Options on Futures

Chapter 13

11

The Market of Options on Futures

Chapter 13

12

Pricing Options on Futures

Recall from Chapter 12:
European Options
European options can be exercised only on the maturity
date.
American Options
American options can be exercised any time prior to
maturity.
The Black-Scholes model focus best on European options
which avoids problems with early exercise and dividends.
When there is a dividend and the dividend rate varies, the
Black-Scholes model is not suitable for valuing options on
futures.
The Black-Scholes model can be modified for forward
option pricing.

Chapter 13

13

Graphical Approach to American Options

on Futures
Figure 13.2 illustrates how European options prices are
good approximations for American futures option prices
Insert figure 13.2 here

Chapter 13

14

Black-Scholes Model for Options on

Forward Contracts
The Black-Scholes equation for option on forward
contracts is:

C=e

- rt

[ F 0,t N( d *1 ) - E N( d *2 )]

Where
r = risk-free rate of interest
t = time until expiration for the forward and the option
F0,t = forward price for a contract expiring at time t
= standard deviation of the forward contracts price

*
1

ln( F / E ) .5 2 t

d * 2 d *1 t
If there were no uncertainty, N(d1*) and N(d2*) will equal
1 and the equation would simplify to:
Cf = e-rt[F0,t - E]

Chapter 13

15

European Versus American Option on

Futures
European Options
Early exercise of an option on a non-dividend paying stock
is not recommended:
Recall that upon exercising, the call owner receives the
intrinsic value (S E).
Exercising a call discards the excess value of the option
over and above S E.

American Options
Early exercise of a dividend paying futures option has
benefits and costs
Benefit: exercise provides an immediate payment of F E
which can earn interest until expiration ert [F - E].
Cost: sacrifice of option value over and above intrinsic
value F E.

Chapter 13

16

Approximating European and American

Futures Option Values
Table 13.2 compares the theoretical values for
European and American options on futures. The table
assumes that the option on futures expires in half a year
and has an exercise price of $100. The risk-free rate of
interest is 8% and the standard deviation of the
percentage change in the futures price is 0.2.

Chapter 13

17

Efficiency of The Option on Futures

Market
Most tests of efficiency examine whether market prices
match the prices of a theoretical model.
A test of market prices against a theoretical model is a joint
test of the market's efficiency and the model's ability to
correctly represent the price.
The results of Whaleys test for efficiency are presented in
Table 13.3.

The differences between the theoretical and market price

are significant here.
Chapter 13

18

Efficiency of The Option on Futures

Market
Some of the studies summarized in Table 13.4 compare
actual prices with Black model prices.

Chapter 13

19

Price Relationship Between Options on

Physicals and Options on Futures
In this section, the pricing relationship between options on
physicals and options on futures is considered, specifically
for call options. The analysis is organized as follows:
1. European options
2. American options on underlying assets with no cash
flow
3. American options on underlying assets with cash flow

Chapter 13

20

Price Relationship Between Options on

Physicals and Options on Futures
The following assumption will be held for this analysis:
1.

The options have the same expiration and exercise

price.

2.

The options are on the same underlying commodity.

One option is on the commodity itself.
One option is on the futures on the commodity.

Chapter 13

21

European Options on Physicals and

Futures
Recall from Chapter 12 that at expiration a call option on
the physical will be worth:
S-E
For European options on futures, exercise can occur only
at expiration, so it must be that:
Ft,t - E = St - E
For European options the exercise value for options on
physicals and options on futures is the same.

Chapter 13

22

American Options on Physicals and

Futures with No Underlying Cash Flows
For American options, any difference in value between
options on physicals and options on futures results from the
early exercise privilege. Table 13.5 shows the exercise
values that the option on the futures can have given the
option on physicals in percentage terms. The risk-free rate is
assumed to be 15% and the percentage change in the
underlying assets is .25.

Chapter 13

23

American Options on Physicals and

Futures with Underlying Cash Flows
This analysis is particularly relevant to options on stock
indexes and options on stock index futures.
Cash flows from the underlying good reduce its value.
When stock pays a dividend, the stock price drops by
approximately the amount of the dividend.

These cash flows affect both the option on the physical and
the option on the futures.
The analysis focuses on underlying physical asset paying a
continuous dividend (cash flow) equal to the risk-free rate
of interest.
Under conditions of certainty, a futures call option is worth
the present value of:
F0,t E, t = 0
Based on the perfect markets Cost-of-Carry Model the
futures price will be:
F0,t = S0(1 + C)
Chapter 13

24

American Options on Physicals and

Futures with Underlying Cash Flows
For financial futures, the cost of carry is the risk-free
interest rate. Assume a continuous dividend equal to the
risk-free rate of interest. In this case, the cost of carry is
zero, so the futures call option price equals:
F0,t = S0erte-rt = S0
Substituting the value of F0,t into the Black-Scholes OPM
gives an adjusted Black-Scholes OPM of:
C f = e rt [ S 0 N( d *1 ) EN( d *2 )]

where:
Cf = the price of a call option on the futures
After adjusting the Black-Scholes model for continuous
paying dividend:
C f = e-rt S 0 N( d *1 ) - e - rt EN( d *2 )

C f = e-rt S 0 N( d 1 ) - EN( d 2 )
The values for the call option on the futures and physical are
the same. That is, d1* = d1, and d2* = d2.
Chapter 13

25

Relative Prices of Options on Physicals

and Futures
The implications of this analysis for various dividend rates
are:

Chapter 13

26

Put-Call Parity for Options on Futures

Recall that Put-Call Parity specifies a relationship between
the price of call and put options.
For non-dividend paying assets put-call parity equals:

C - P = S0 - Ee-rt
where:
C
P
E
S0
r
t

=
=
=
=
=
=

value of a call with exercise price E

value of a put with exercise price E
exercise price of both the call and put
stock price
risk-free rate of interest
time until the options expire

Chapter 13

27

Put-Call Parity for Options on Futures

Before expiration, for options on futures, the relationship
can be expressed as:

Cf - Pf = (F0,t - E)e-rt
where:
Cf

= futures call option with exercise price E

Pf

= futures put option with exercise price E

F0,t

= current futures price

= common exercise price for Cf and Pf

= risk-free rate

= time until expiration for the futures and options

Comparing both equations shows the similar structure of

put-call parity for options on physicals and on futures.

Chapter 13

28

Put-Call Parity for Options on Futures

Using continuous compounding, the Cost-of-Carry Model
for a perfect market is:

F0,t = S0ert
Substituting this expression for the futures price into the
above equation gives:

Cf - Pf = (S0ert - E)e-rt = S0 - Ee-rt

Chapter 13

29

Options on Futures and Synthetic

Futures
Synthetic Futures
A position that duplicates the profits and losses from a
futures, but consists of positions in other instruments.
Creating synthetic futures equals:
Futures Call - Futures Put = Synthetic Futures
Table 13.6 summarizes the rules for constructing synthetic
positions.

Chapter 13

30

Risk Management with Options on

Futures
This section explores examples related to risk
management including:
Portfolio Insurance
Synthetic Portfolio Insurance and Put-Call Parity
Risk and Return in Insured Portfolios

Chapter 13

31

Risk Management with Options on

Futures Example
Assume: a stock index is currently at $100. Stocks in the
index pay no dividends, and the expected return on the
index is 10% with a standard deviation of 20%. A put option
on the index with an exercise price of $100 is available and
costs $4. Consider three investment strategies:
Portfolio A :
(uninsured)

Buy the index; total investment $100.

Portfolio B:
(half insured)

Buy the index and one-half of a put; total

investment $102.

Portfolio C:
(fully insured)

Buy the index and one put; total

investment $104.

At expiration, the three portfolios will have profits and

losses computed using the following equations:
Portfolio A:

Index Value - $100

Portfolio B:

Index Value + .5 MAX{0, Index Value

$100} - $102

Portfolio C:

Index Value + MAX{0, Index Value

$100} - $104

Chapter 13

32

Risk Management with Options on

Futures
Figure 13.4 graphs the profits and losses of these 3 portfolios.

Insert Figure 13.4 here

Chapter 13

33

Portfolio Insurance
Recall that in portfolio insurance, a trader transacts to
insure that the value of a portfolio does not fall below a
given amount.
Based on figure 13.4, portfolio C is an insured portfolio:
The value of portfolio C cannot fall below $100. To create
portfolio C, a trader bought the index at $100 and bought an
index put with an exercise price of $100.

The worst possible loss on portfolio C is $4. Portfolio C

must always be worth at least $100 because the value can
not fall below $100, so it an insured portfolio.

Chapter 13

34

Synthetic Portfolio Insurance and PutCall Parity

Recall that a synthetic call could be created from a long
position in the underlying good plus a long put. Thus a
synthetic call is:
Synthetic Call = Put + Index
From Figure 13.4, the Put + Index portfolio has the same
profits and losses as a call option with an exercise price of
$100.
Applying the put-call parity equation to the index example:
Call = Put + Index - Ee-rt
where:
E = exercise price on the index option
An instrument with the same value and profits and losses
as a call can be created by holding a long put, long index,
and borrowing the present value of the exercise price.

Chapter 13

35

Synthetic Portfolio Insurance and PutCall Parity

From the put-call parity, there is another way to create a

portfolio that exactly mimics the insured portfolios value at
expiration.
Call + E-rt = Put + Index
We can hold a long call plus investing the present value of
the exercise price in the risk-free asset.

Chapter 13

36

Risks Return on Insured Portfolios

Each of the portfolios A-C has different risk characteristics.
To explore the risk properties of the portfolios assume that
the return on the index follows a normal distribution with a
mean of 10% and a standard deviation of 20%.
Terminal Values for Portfolios A-C.
The portfolio values at expiration depend on the price of
the index at expiration. For each, the terminal value is:
Portfolio A = Index
Portfolio B = Index + MAX{0, .5(100.00 - Index)}
Portfolio C = Index + MAX{0, 100.00 - Index}
What is the probability that each of the portfolios will have
a terminal value equal to or less than $100?

Chapter 13

37

Risk Return in Insured Portfolios

Table 13.7 shows some portfolio values and the
probabilities that each portfolio will be equal to or less than
the given terminal value at the expiration date.

Chapter 13

38

Risk Return in Insured Portfolios

Figure 13.5 graphs the terminal portfolio values from $50 to
$170 and shows the probability for each portfolio that the
terminal portfolio value will be below or equal to the given
amount.

Insert Figure 13.5 here

Chapter 13

39

Risk Return in Insured Portfolios

Returns on Portfolios A-C
Table 13.8 shows the probability that each portfolio will
achieve a return greater than a specified return.

This is a tradeoff between return and risk on the portfolios.

The portfolios having a higher return also have a higher
risk.
Chapter 13

40

Risk Return in Insured Portfolios

Figure 13.6 graphs the probabilities for each portfolio for a
range of returns from -50% to 50%.

Insert Figure 13.6 here

Chapter 13

41

Why Options on Futures

Some reasons for the popularity of options on futures are:
1. A futures position exposes a trader to a theoretically
unlimited risk of gain or loss, but this is not true for the
buyer of a futures option.
2. Options on futures dominate options on physicals in
some markets because the futures market for some
goods is much more liquid than the market for the
physical good itself.
3. Options on futures generally require less investment
than options on the physical good itself.

Chapter 13

42