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

2. Outline Futures options Pricing futures options Warrants
Other derivative assets

3. 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

4. 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

5. 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

6. 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

7. 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

8. Characteristics (cont’d)
Futures Prices
February 10, 2004
S&P 500 Index
Open
High
Low
Settle
Change
MAR
+330
JUN
+340
SEP ….
+320
DEC
+350

9. 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

10. 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

11. 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

12. 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 cents. The money at risk is
3 contracts x 5,000bu/contract x $0.2525/bu = $3,787.50

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

14. 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.

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

16. 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

17. 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

18. 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.

19. 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

20. 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

21. 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

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

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

24. 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:

25. 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

26. 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

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

28. 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

29. Warrants
Characteristics
Pricing
Hedging with stock warrants

30. 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

31. 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

32. 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

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

34. 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

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

36. 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

37. 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
$8.00
$23.23
Collegiate Pacific
BOO
$5.00
$5.15
$10.05
Image Ware Systems IW
$12.00
4-5-05
$0.05
$4.40

38. 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

39. 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

40. 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

41. Other Derivative Assets
Foreign currency options
When-issued stock

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

43. 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

44. 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

45. 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

46. 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