Topic 9

Options on Futures, Currency Derivatives and

Exotic Options

Pricing Options on Futures

Triangular Arbitrage and Interest Rate Parity
Pricing Currency Derivatives
Some Popular Exotic Options

Introduction
Pricing more advanced futures and options are not
necessarily hard to understand
Based on the same futures pricing model
Based on the same Black-Scholes model
If you know standard futures and option pricing
models, you will automatically understand other exotic
variations.

Characteristics of Options on
Futures
Options where exercise establishes either a long or
short position in a futures contract at the exercise
price

Exercise of long (short) call establishes a long (short)

futures.
Exercise of a long (short) put establishes a short (long)
futures.

Also called commodity options or futures options.

Options on Futures
For example, a TCC ltd. futures call option has a
current price of $2.75

$1,000 multiplier / contract size

Therefore the cost is $2,750.00

If exercised when futures = 121, holder establishes long

futures position at 115, which is immediately marked to
market at 121 for a $6,000 credit to margin account {that is 121115 =6}.

Note: expiration can be the same month as futures or earlier,

depending on the contract.
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Pricing Options on Futures

The Intrinsic Value of an American Option on
Futures

Minimum value of American call on futures

Minimum value of American put on futures

Ca(f0,T,X) Max(0,f0 - X)

Pa(f0,T,X) Max(0,X - f0)

Difference between option price and intrinsic value is

time value.
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Pricing Options on Futures

The Lower Bound of a European Option on
Futures

Ce(f0,T,X) Max[0,(f0 - X)(1+r)-T]

How did we get this?

Note: f0 = S0(1+r)T

Pe(f0,T,X) Max[0,(X - f0)(1+r)-T]

Pricing Options on Futures

Put-Call Parity of Options on Futures
Payoffs from Portfolio
Portfolio
A

Current Value
Long Futures
Long Put

Pe ( f 0 , T , X )

fT X

fT X

fT f 0
X fT

fT f 0

X f0

Long Call
Bonds

Ce ( f 0 , T , X )
( X f 0 )(1 r ) T

X f0
X f0

fT f 0

fT X
X f0

fT f 0
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Pricing Options on Futures

Put-Call Parity of Options on Futures

Pe(f0,T,X) = Ce(f0,T,X) + (X - f0)(1+r)-T.

Compare to put-call parity for options on spot:

Pe(S0,T,X) = Ce(S0,T,X) - S0 + X(1+r)-T.

If options on spot and options on futures expire at same

time, their values are equal;
implying f0 = S0(1+r)T.

Pricing Options on Futures

Early Exercise of Call and Put Options on Futures

Deep in-the-money call may be exercised early because

behaves almost identically to futures

exercise frees up funds tied up in option but requires no funds to

establish futures

minimum value of European futures call is less than value if it

could be exercised

Similar arguments hold for puts

Pricing Options on Futures

Options on Futures Pricing Models

Black model for pricing European options on

futures
C e rc T [f 0 N(d1 ) XN(d2 )]
where

ln(f 0 /X) 2 /2 T
d1
T
d 2 d1

T
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Pricing Options on Futures

Options on Futures Pricing Models

Note that with the same expiration for options on spot as

options on futures, this formula gives the same price.

Blacks model ONLY works when futures and options have the
same termination date.

For puts
P XercT [1 N(d2 )] f0ercT [1 N(d1)]
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The Foreign Currency Market

and Currency Derivatives
The Nature of Exchange Rates

Definition: the rate at which the currency of one

country can be translated into the currency of
another country.
Can be viewed as the price in one currency of
purchasing another currency. Similar concept to
price of any other asset.

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The Foreign Currency Market

and Currency Derivatives
Foreign Currency Spot and Forward
Markets

Called the Interbank Market.

Notional value of currency forwards currently
exceed $10 trillion in any particular year.
Most heavily traded currencies are US dollar,
Euro, Yen, Swiss Franc and Pound Sterling.

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Pricing Foreign Currency

Derivatives
Cross-Rate Relationships must hold

Else, arbitrage opportunities exist

Example:
$/ = price of British pound in Australian dollars
/$ = price of Australian dollars in yen

/ = price of yen in pounds

Therefore: ($/ )(/)(/$) = 1

If not, then (triangular) arbitrage can be executed.

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Pricing Foreign Currency

Derivatives
Cross-Rate Relationships

Lets say current spot rates are:

268/

0.3482/$
Then, using:

$
1
$

The price of Yen in Australian dollars must equal:

$0.0107/ as (268)(0.3482)(0.0107)=1

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Pricing Foreign Currency

Derivatives
Cross-Rate Relationships

What happens if $0.0134/ ?

Yen is overvalued relative to the dollar

Take 1 pound and convert to 268.

Take 268 and convert to (268)(0.0134)=$3.591
Then convert back:
Take $3.591 and convert to (3.591)(0.3482)=1.25
This is a 25% return, with no risk!

Such arbitrage no longer exists

Go to the nearest FX changer in a Bank check to see if

money can be made from the quoted cross-rates!
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Pricing Foreign Currency

Derivatives
Interest Rate Parity

The relationship between spot and forward / futures prices of a

currency. Same as cost of carry model in other forward and
futures markets.

Proves that one cannot borrow and convert a domestic currency to

another foreign currency, sell a futures, earn the foreign risk-free

rate and convert back risklessly, earning a rate higher than the
domestic rate.
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Pricing Foreign Currency

Derivatives
Interest Rate Parity an example:

S0 = spot rate in domestic currency per foreign currency.

Lets say Yen per Singapore Dollar.

Foreign interest rate is r.

In this case it is the Singapore risk-free rate.

Holding period is T.

Domestic rate is r.
This would be the risk-free rate in Japan.

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Pricing Foreign Currency

Derivatives
Interest Rate Parity

Take S0(1+ r)-T Yen and buy (1+ r)-T Singapore Dollars.

Place your Singapore dollars in the bank earning rreturn.

Simultaneously, you sell one forward contract to deliver 1 Singapore

Dollar at T at price F0.

At time T:
Your Singapore dollars will be worth 1 dollar.
Your (1+ r)-T will have grown by (1+ r)-T x (1+ r)T = 1.
Your forward contract obliges you to deliver the Singapore dollar and receive

F0 Yen
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Pricing Foreign Currency

Derivatives
Interest Rate Parity

What has this led to?

You invested S0(1+ r)-T Yen and received F0 Yen.
You earn the Japanese risk free rate as the above transaction is riskless

That is:

F0 = S0(1+ r)-T(1 + r)T

This is called interest rate parity.

Sometimes written as
F0 = S0(1 + r)T/(1 + r)T

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Pricing Foreign Currency

Derivatives

Difference between domestic and foreign rate is

analogous to difference between risk-free rate

and dividend yield on stock index futures.

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Pricing Foreign Currency

Derivatives
Currency Options

Minimum value of American foreign currency call is

Ca(S0,T,X) Max(0,S0 - X).

Minimum value of American foreign currency put is

Pa(S0,T,X) Max(0,X - S0).

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Pricing Foreign Currency

Derivatives
The Lower Bound of European Foreign
Currency Options

Calls:

Ce(S0,T,X) Max[0,S0(1+ r)-T - X(1+r)-T].

This must hold for American options too.
Note similarity to case of call on stock with dividend yield.

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Pricing Foreign Currency

Derivatives

Puts:

Pe(S0,T,X) Max[0,X(1+r)-T - S0(1+ r)-T].

This must hold for American options too.
Note similarity to case of put on stock with dividend yield.

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Pricing Foreign Currency

Derivatives
Put-Call Parity

S0(1+ r)-T + Pe(S0,T,X) = Ce(S0,T,X) + X(1+r)-T

Note similarity to put-call parity for options on stocks.

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Pricing Foreign Currency

Derivatives
The Garman-Kohlhagen Foreign Currency
Option Pricing Model
-r T

-r T

C=S0e c N(d1 ) Xe c N(d2 )

where
d1

ln(S0e

- rc T

d2 d1 T

/ X)+[rc ( 2 / 2)]T

Identical to Black-Scholes model for options on

stocks with dividend yields using r for dividend
yield.

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Some Exotic Options

Digital Options

Digital options, sometimes called binary options,

are of two types.
Asset-or-nothing options pay the holder the asset if the
option expires in the money and nothing otherwise.
Cash-or-nothing options pay the holder a fixed
amount of cash if the option expires in the money and
nothing otherwise.

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Some Exotic Options

Payoffs from Portfolio

Long asset-or-nothing option

Short cash-or-nothing option

ST X

ST X

0
0

ST
-X

ST X

This combination is equivalent to an ordinary European call.

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Some Exotic Options

Recall that the Black-Scholes price is

S 0N (d 1 ) Xe rcT N (d 2 )

The first term is the price of the asset-or-nothing option.

The second term, ignoring the minus, is the price of a cashor-nothing option that pays off X if it expires in-the-money.
The prices of an asset-or-nothing option and cash-ornothing option are:

Oaon S0N(d1 )
Ocon Xe

rc T

N(d2 )
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Some Exotic Options

Chooser Options

Enable the investor to decide at a specific time after

purchasing the option but before expiration that the
option will be a call or a put.
Assume that decision must be made at time t < T
The chooser option is identical to

an ordinary call expiring at T with exercise price X plus

an ordinary put expiring at t with exercise price X(1+r)-(T-t)

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Some Exotic Options

Chooser Options

Example: Comparison with a Straddle

Coca Cola Amatil U.S. chooser option in which choice must be made in 25
days.
Call/put expires in 47 days.

S0 = 9.32,
X = 9,
= .76,
rc = .0512.
T = 47/365 = .1288,
t = 25/365 = .0685
so T - t = .1288 - .0685 = .0603.

Exercise price on put used to price the chooser is 9(1.0512)-.0603 = 8.9729.

Using Black-Scholes model, put is worth $0.5457. Thus the call

is worth $1.1914, the put is equal to $0.5457, for a total of
$1.7371.
A straddle would cost $1.19 + $0.81 = $2.
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Path-Dependent Options

Payoff determined by the sequence of prices

followed by the asset and not just by the price

of the asset at expiration.

Priced using the binomial model

In practice the binomial model is difficult to use

for path-dependent options.
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Path-Dependent Options
Asian options:
Average price options:

final payoff is determined by the average price of the

asset during the options life.

Average strike options

The average price substitutes for the exercise price at

expiration.

When are they used?:

Useful for hedging or speculating when the average is

acceptable.
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Path-Dependent Options

Lookback Options
Also called a no-regrets option, it permits
purchase of the asset at its lowest price during
the options life or sale of the asset at its highest
price during the options life.

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Path-Dependent Options
Lookback options

Four different types:

lookback call:

Min price for X

lookback put:

Xmax

Xmin

Max price for X

fixed-strike lookback call:

Max price for ST

fixed-strike lookback put:

Min price for ST

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Path-Dependent Options

Barrier Options

Terminate /Activate if the asset price hits a certain level, called the
barrier.
The former is called a knock-out option (or simply out-options)
The latter is called a knock-in options (or simply in-options).

If the barrier is above the current price, it is called an up-option.

If the barrier is below the current price, it is called a down-option.

Will Barrier Options be more or less expensive than Standard

European Options?
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Path-Dependent Options

Other Exotic Options:

compound and installment options
multi-asset options, exchange options, min-max
options (rainbow options), alternative options,
outperformance options
shout, cliquet and lock-in options
contingent premium, pay-later and deferred strike
options
forward-start and tandem options

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