Other Derivative Assets Chapter 15 Other Derivative Assets © 2004 South-Western Publishing

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 Speculators and hedging Early exercise of futures options

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

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

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

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

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 1142.30 +340 SEP …. 1141.40 +320 DEC 1139.00 1141.20 +350

Characteristics (cont’d) Futures Options Prices February 10, 2004 S&P 500 Index Calls Puts Strike Price 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

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

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

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

Spreading With Futures Options Used by speculators in futures options to reduce their money at risk E.g., construct a bullspread

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.

Spreading With Futures Options (cont’d) Bullspread Example Futures Settlement Price (cents per bushel) 858 860 862 864 866 Buy 8600 call @ $.07 -7 -5 -3 -1 Write 8700 call @ $.05 +5 Net -2 +2 +4

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

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

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.

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

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

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

Pricing Futures Options Futures option pricing model Disposing of valuable options Futures option deltas Implied volatility

Futures Option Pricing Model Black’s futures option pricing model for European call options:

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:

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

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

Futures Option Deltas Slightly different from delta for equity or index options Call delta: Put delta:

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

Warrants Characteristics Pricing Hedging with stock warrants

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

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

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

Characteristics (cont’d) The vast majority of warrants are from small, relatively risky firms, often issued in conjunction with an IPO

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

Pricing (cont’d) Actual Maximum warrant Warrant value price Minimum Price value Exercise price Stock price

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

New York Stock Exchange Warrants 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

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

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

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

Other Derivative Assets Foreign currency options When-issued stock

Foreign Currency Options Foreign currency options began trading in 1982 Commercial banks arrange most currency option trading Contracts guaranteed by Options Clearing Corporation

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

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

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

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