Business School

ACTL4303 AND ACTL5303

ASSET LIABILITY MANAGEMENT

Week 11
Futures, Options and Other Derivatives

Revision - Economic Scenario Generators

In evaluating an ESG, consider:
What is the purpose? (eg Long-term strategy assessment or short-term
solvency tests)
Critically, evaluate the theory and thinking behind the model structure
Is the model calibrated on a relevant dataset (eg inflation since inflation
targeting monetary policy regime)?
How does the model contemplate extreme equity behavior?
Are the linkages between asset classes and inflation reasonable and
practical?
Is the model hostage to theory and in contradiction of data or vice versa?

Revision - Economic Scenario Generators

Consider an ESG that derived equity returns based on the following
equations:

E
P

= a + b y + t

where yt is the bond yield

E =E
t

t1

(1+ g )
t

g = GDP + INF + g
t

Valuing the stock market in aggregate the Fed

model (now discredited)
E / P y + ERP b ROE
EY / Bond =
=
y
(1 b)y

ERP b(ROE y)
= 1+
(1 b)y

Popularised in Fed commentary in the late 1990s but

always suspect
Through the 1980s and 1990s earnings yield and bond
yields moved closely together
The relationship broke down in the early 2000s
In theory the ratio will vary over time depending on
changing Equity Risk Premum (ERP) and growth
prospects (ROE) variations not mispricing

Expected Equity Returns Market Implied (4)

g = GDP NI (nominal economic growth less new investment)
The profit share of GDP should be reasonably constant
So corporate profits should grow in line with nominal GDP
The asset base for corporate profits is expanded by new
capital raising so adjustment is necessary
Capital raisings on the ASX consist of IPOs and secondary
capital raisings by companies already listed
The appropriate adjustment to growth with this approach
corresponds to secondary raisings as a % of market cap
This figure is typically 2-3%
With nominal GDP of circa 5-5.5%, that implies growth of circa
3%.

This weeks coverage

Bodie et al
Chapter 20
Chapter 21
Chapter 22
Chapter 23

Options markets: Introduction

Option valuation
Futures markets
Futures and swaps: a closer look

The Option Contract: Calls

A call option gives its holder the right to
buy an asset:
At the exercise or strike price
On or before the expiration date

Exercise the option to buy the underlying

asset if market value > strike price.

INVESTMENTS | BODIE, KANE, MARCUS

The Option Contract: Puts

A put option gives its holder the right to
sell an asset:
At the exercise or strike price
On or before the expiration date

Exercise the option to sell the underlying

asset if market value < strike price.

INVESTMENTS | BODIE, KANE, MARCUS

The Option Contract

The purchase price of the option is called
the premium.
Sellers (writers) of options receive
premium income.
If holder exercises the option, the option
writer must make (call) or take (put)
delivery of the underlying asset.

INVESTMENTS | BODIE, KANE, MARCUS

Market and Exercise Price Relationships

In the Money - exercise of the option produces a
positive cash flow
Call: exercise price < asset price
Put: exercise price > asset price
Out of the Money - exercise of the option would not
be profitable
Call: asset price < exercise price.
Put: asset price > exercise price.
At the Money - exercise price and asset price are
equal
10

INVESTMENTS | BODIE, KANE, MARCUS

Option Values
Intrinsic value - profit that could be made if
the option was immediately exercised
Call: stock price - exercise price
Put: exercise price - stock price
Time value - the difference between the
option price and the intrinsic value, given
immediate expiration

11

INVESTMENTS | BODIE, KANE, MARCUS

Figure 21.1 Call Option Value

before Expiration

12

INVESTMENTS | BODIE, KANE, MARCUS

Restrictions on Option Value: Call

Call value cannot be negative. The option
payoff is zero at worst, and highly positive at
best.
Call value cannot exceed the stock value.
Value of the call must be greater than the
value of levered equity.
Lower bound = adjusted intrinsic value:
C > S0 - PV (X) - PV (D)
(D=dividend)
13

INVESTMENTS | BODIE, KANE, MARCUS

Option Basics

Source: ASX

14

ASX Clear

Exchange traded options simplify counterparty risk

But the buyer and writer still rely on the viability of their
brokers

15

A recent example of counterparty risk

BBY failure hits long list of securities dealers
The failure of stockbroking and advisory firm BBY has hit
as many as 31 securities dealers that used the company
for clearing trades, spurring confusion about the transfer
of end-clients and clearing operations to other firms..
The Sydney-based company run by executive chairman
Glenn Rosewall was placed into voluntary administration on
Monday, after failing to repay loans to lender St George. The
decision was, however, a week in the making after BBY
wasn't able on May 8 to meet capital requirements for its
large exchange-traded options positions.
AFR 19/5/15
16

ASX Contract Specifications

17

Put-Call Parity
The call-plus-cash portfolio (on left)
must cost the same as the stock-plusput portfolio (on right) for European
options:
X
C+
= S0 + P
T
(1 + rf )
Call plus Cash = Stock plus Put
18

INVESTMENTS | BODIE, KANE, MARCUS

American vs. European Options

American (stock options) the option can be exercised at any time
before expiration or maturity
European (index options) the option can only be exercised on the
expiration or maturity date
The Black-Scholes model can be used to price an American call with
dividends but not American puts
It can be worthwhile to exercise an American put early (eg after it
goes ex-dividend, or well into the money) so a binomial model is
required
The put-call parity (cash + call = equity + put) does not hold for
American options

19

Black-Scholes formula with dividends

In Australia the share price may fall on the ex-dividend
date by more than the face value of the dividend
because of imputation
This increases the chance of early exercise under
American style
The options value can be approximated as the greater
of
1. Black-Scholes formula with a shortened expiry to
the next dividend date, and using the unadjusted
stock price
2. Black-Scholes formula for full expiry using a stock
price adjusted for the present value of dividend,
allowing for imputation
20

Figure 20.2 Payo and Prot to Call

Option at Expiration

21

INVESTMENTS | BODIE, KANE, MARCUS

Figure 20.3 Payo and Prot to Call

Writers at Expiration

22

INVESTMENTS | BODIE, KANE, MARCUS

Covered Calls
Purchase stock and write calls against it.
Call writer gives up any stock appreciation
above the strike price, X, in return for the
initial premium.
Sometimes investors might be comfortable
long-term holders, but expect no price action
in the short-term
Selling premium adds return IF theyre right
23

INVESTMENTS | BODIE, KANE, MARCUS

Figure 20.8 Value of a Covered Call

Position at Expiration

In the BKM
example X=S0
(at the money)
and profit
where ST=X
will be C
24

INVESTMENTS | BODIE, KANE, MARCUS

Covered Call Writing and the income myth

Common misconception that call writing generates income
The potential upside of a stock is exchanged for an option
premium
Once a stock is called away, the entitlement to its dividend
stream has been foregone at the exercise price
To invest back into that dividend stream at a higher price (eg
$10) with the proceeds of the option exercise (eg $9) will
mean a reduced dividend income (eg $0.50x9/10) compared
to what was previously in place ($0.50)
So potentially some perpetual income is lost in return for oneoff option premium
25

Other Misconceptions about Covered Call Writing

Call writing gives downside protection the call
premium is a minor offset in the event of serious price
weakness
Call writing imposes a sell discipline what if the
price goes up because circumstances change (+ve
earnings guidance)? The investor is compelled to sell
with a written call regardless of circumstances
Volatile stocks generate more income this is an
extension of the income myth. Higher volatility means
bigger premium and greater liability.

26

Option strategies
Option strategies may be based on a view of volatility
(eg straddles, call writing). The writer of options
expects less volatility than implied by option prices.
Or based on a directional view (eg a put option on a
stock or index) which reflects a skew on perceived
market outcomes
Remember stock volatility has a systematic element
and a stock specific element.
So an option writer may be correct in thinking banks
wont outperform the market, but be called away
because the market rallies
27

Finite horizon and costs

An option strategy is about an outcome over a finite
horizon (you need to be right within the time to expiry)
Some market views may ultimately prove correct, but
long after the expense of time decay has exhausted
patience for the strategy
The cost of an option strategy can be managed by
moving further away from the money, or by using a
spread (writing a further away option to offset the nearthe-money premium)

28

Portfolio context
Does it make sense for an equity manager to buy put
options on selected stocks to protect a portfolio?
This is cumbersome and costly
A skewed market view is better expressed through index
options which apply to the whole portfolio
If a manager is employed for stock selection skills should
the mandate indulge option strategies?
Option strategies should never be allowed to leverage a
portfolio so (delta adjusted exposure premium) must
be backed by cash equivalents
Complicated strategies with high gamma can lurch to
leverage very quickly, requiring robust risk management
29

ASX Options on the index (S&P/ASX 200)

Note index option contract value is 10 times the index points, whereas the
futures contract is 25 times, so 1 contract = $45,000 above
Increase in intrinsic value ($15,000) is offset by the erosion of time value
Portfolio performance (-$20,000) can vary from index (-$15,000)
30

Figure 21.9 Call Option Value and Hedge

Ratio

31

INVESTMENTS | BODIE, KANE, MARCUS

Hedging and Delta

The effectiveness of the hedge will depend
on the delta.
Delta is the change in the value of the
option relative to the change in the value
of the stock, or the slope of the option
pricing curve.
Delta =

32

Change in the value of the op1on

Change of the value of the stock
INVESTMENTS | BODIE, KANE, MARCUS

Options as a dynamic levered equity portfolio (1)

Option Pr ice = Delta Share Pr ice Borrowing
For a bought call option to be cash backed a portfolio holds
spare cash to neutralise the implicit leverage
Eg Consider an at the money option with a premium of 5%
of the share value and a delta of 0.5. For a share value of
$10m:
$500,000 = 0.5 x $10m - $4,500,000
If cash backed, this $500,000 would be held in a portfolio
beside a dedicated cash balance of $4,500,000.
The option + cash = equity exposure of $500,000
33

Options as a dynamic levered equity portfolio (2)

Institutional share mandates will typically specify that option
positions are not to create implicit leverage
If a manager cash backs delta-weighted exposure that cash
allocation will need to be constantly reviewed as delta can
change quickly
The conservative alternative is for the manager to hold
enough cash for the delta to move to one, avoiding any
need for constant cash adjustment
Historically the attraction of bought call options for many
equity investors has been the implicit leverage, so
institutional restrictions make these less attractive
34

Table 21.1 Determinants of Call

Option Values

35

INVESTMENTS | BODIE, KANE, MARCUS

Option price partial and second derivatives (Greeks)

Delta change of option price with respect to stock price. Delta
moves to 1 as the option price exceeds strike (call option) and
is more sensitive close to expiry. Traders think of delta crudely
as the probability the option will be in the money at expiry.
Gamma change of delta with respect to stock price
(acceleration). Gamma is high close to expiry. High gamma
means delta adjusted exposure is slippery, and written options
are risky.
Vega change of option price with respect to volatility. Options
become more valuable as volatility increases.
Theta change of option price with respect to time to expiry or
time decay. Time decay is highest for at-the-money options
because time value is proportionately larger.
Rho change of option price with respect to interest rate. Less
relevant for short dated options
36

Time decay (theta)

37

Option gamma (1)

Option delta and gamma for an option with a $50 strike

38

Option gamma (2)

39

Option vega

40

Volatility smiles and smirks

The implied volatility on options is not constant across the
range of strike prices or expiries
The implied volatility for options far out of the money tends to
be higher than for near-the-money options (referred to as a
volatility smile). This can be a symptom of excess kurtosis.
When there is increased interest in protection, this can create a
skew to the smile (a smirk) where implied volatilities for out-ofthe-money puts/in-the-money-calls are higher than for in-themoney puts/out-of-the-money calls.
The skew may be reversed for commodities
The is also a term structure to volatility where the implied
volatilities vary by period to expiry
Mispricing on the basis of implied volatilities needs to be
interpreted carefully

41

Futures and Forwards

Forward a deferred-delivery sale of an asset
with the sales price agreed on now.

Futures - similar to forward but feature

formalized and standardized contracts.
Key difference in futures
Standardized contracts create liquidity
Marked to market
Exchange mitigates credit risk

42

INVESTMENTS | BODIE, KANE, MARCUS

Basics of Futures Contracts

A futures contract is the obligation to make or
take delivery of the underlying asset at a
predetermined price.
Futures price the price for the underlying
asset is determined today, but settlement is
on a future date.
The futures contract specifies the quantity
and quality of the underlying asset and how
it will be delivered.
43

INVESTMENTS | BODIE, KANE, MARCUS

Basics of Futures Contracts

Profit to long = Spot price at maturity - Original
futures price
Profit to short = Original futures price - Spot
price at maturity
The futures contract is a zero-sum game, which
means gains and losses net out to zero.

44

INVESTMENTS | BODIE, KANE, MARCUS

Existing Contracts
Futures contracts are traded on a wide
variety of assets in four main categories:
1.
2.
3.
4.

45

Agricultural commodities
Metals and minerals
Foreign currencies
Financial futures

INVESTMENTS | BODIE, KANE, MARCUS

Trading Mechanics
Open interest is the number of contracts
outstanding.
If you are currently long, you simply instruct your
broker to enter the short side of a contract to
close out your position.
Most futures contracts are closed out by
reversing trades.
Only 1-3% of contracts result in actual delivery of
the underlying commodity.
46

INVESTMENTS | BODIE, KANE, MARCUS

Figure 22.3 Trading without a Clearinghouse;

Trading with a Clearinghouse

47

INVESTMENTS | BODIE, KANE, MARCUS

Share Price Index (SPI) Futures

Investment managers use SPI Futures to equitise spare
cash pending physical investment (eg they receive a new
cash allocation to a portfolio from a client)
Alternatively when a client redeems cash they may instruct
for the transfer from the portfolio to take place at the end of
the month, until which time the manager is to keep the
portfolio exposed to the market
Because of settlement delays in selling physical stock (T+3),
and market liquidity the manager may progressively sell
fractions of the portfolio over several weeks
As the cash accumulates, futures are bought to keep it
equitised until it is transferred out of the portfolio
48

ASX Contract Specifications

49

Fair Value for the Futures Price (1)

Holding cash covered by futures contracts should give the
same outcome as holding the underlying index portfolio, if
both are held until maturity
The cash backing the futures will earn interest, while the
index portfolio will earn dividends
The index portfolio and the futures price will be equal at
expiry by definition of the futures contract
(Index at Expiry Index Today) + Dividends
= (Index at Expiry Futures Price Today) + Interest
Futures Price Fair Value = Index Today + Interest Dividends
The Futures basis = Index Today Futures Price Today
So actual Futures Price is Index minus current basis
50

Fair Value for the Futures Price (2)

The Fair Value Futures Price is determined by the difference
between interest and dividends in the period until futures
expiry
But it varies with the tax status of the investor, so it is a fuzzy
concept
For a SPI contract expiring in 3 months time assume interest
of 0.5% (2%pa) and dividends over the period of 1.5%
If we assume average franking of 80%, for a superannuation
investor paying 15% the futures fair value relative to physical
would be:
0.85 x (0.5% (0.2+0.8/0.7)x1.5%) = -1.3%
The actual is loosely indicative of the average tax status of
investors
51

Deposits and Margins (SPI contract)

On opening a position through a futures broker an investor
pays a deposit set by broker, say $6000 per contract. C
Contract value is 25 x index level (eg 25x5200=130,000)
Each day the position is marked to market resulting in the
adding of gains or subtracting of losses from the account
If as a result of mark-to-market the account balance falls
below initial deposit, an additional variation margin will be
called
At close of contract, deposit (and any accumlated net
profit) is recoverable
Your broker is your counterparty. Their counterparty is ASX
Clear.
52

Deposits and Margins (SPI contract)

Your $50m equity portfolio has $1,500,00 spare cash (3%)
To equitise the cash you buy 10 SPI Futures contracts with the futures
at 5200 (each contract face value is 25 x futures price)
Total face value is 10 x 25 x 5200 = $1,300,000
Your net effective cash position is reduced to $200,000 (0.4%)

53

Calculating Futures Profit (Loss)

Net Profit = Closing Account Balance Deposits
= 72,500 (60,000 + 25,000)
= -12,500
Net Profit = Sum of Mark to Market Adjustments
= 12,500 + 12,500 50,000 + 12,500
= -12,500
Net Profit = (Closing Price Opening Price) x FV x Contracts
= (5,150 5,200) x 25 x 10
= -12,500
The Net Profit is relative to the value of the opening position
($1,300,000) or circa -1%
54

Basis and Basis Risk

Basis Risk - variability in the basis means

that gains and losses on the contract and
the asset may not perfectly offset if
liquidated before maturity.

55

INVESTMENTS | BODIE, KANE, MARCUS

Hedging Systematic Risk

To protect against a decline in stock prices, short
the appropriate number of futures index contracts.
Less costly and quicker
Use the beta for the porAolio to determine the
hedge ra1o.

56

INVESTMENTS | BODIE, KANE, MARCUS

Australian 10 year bond futures

Note the difference in contract unit (bond value) and price quotation
(100-Yield)

57

Rolling Futures
Equity managers will often carry some spare cash and
equitise with a futures overlay
Withdrawals and new inflow to a portfolio will be transacted
in stock gradually so excess cash will be covered by futures
As the current contract approaches expiry the position will
need to be closed and a new position opened in the next
calendar contract (eg sell September, buy December)
referred to as rolling the position
This creates an element of rolling pressure distortion near
expiry
Managers need to watch the calendar spread of the
contracts to optimize the roll. Dont leave until last day!
58

Rolling Futures
Equity managers will often carry some spare cash and
equitise with a futures overlay
Withdrawals and new inflow to a portfolio will be transacted
in stock gradually so excess cash will be covered by futures
As the current contract approaches expiry the position will
need to be closed and a new position opened in the next
calendar contract (eg sell September, buy December)
referred to as rolling the position
This creates an element of rolling pressure distortion near
expiry
Managers need to watch the calendar spread of the
contracts to optimize the roll. Dont leave until last day!
59

Currency Forwards and Interest Rate Parity

Consider two riskless alternatives:
1. Invest in $A100m in Australia at iAU of 2%pa for three
months
2. Convert $A100m to $US at spot exchange, S, of $US0.73,
invest in US at iUS of 0.15%pa for three months, then convert
back to $A at the $US/$A 3 month forward exchange rate,
F3m
For there to be no arbitrage:
$A100m x (1+0.02x3/12) =($100mx0.73)x(1+0.0015x3/12)/F3m
F3m = 0.73x(1+0.0015x3/12)/(1+0.02x3/12)
= 0.7266
60

Currency Forwards and Interest Rate Parity (2)

The general formula is

$US/$AU

= S $US/$AU

1+ iUS
1+ i AU

Essentially currency forwards are determined by interest rate

differentials
Because Australia tends to have higher interest rates than
US, Europe, UK and Japan, the forward exchange rates
against these currencies will be weaker
Consequently when overseas investments are currency
hedged, the translated return is enhanced by the embedded
interest differential, relative to unchanged spot rates.
61

Currency hedging in practice

A global equity portfolio will be spread across a wide range
of currencies
However by value weight, the bulk can be represented by
the major currencies of $US, Euro, GBP, and Yen (circa
90% of MSCI World)
MSCI calculates currency hedged global equity indices and
these may encourage more detailed hedging practices

62

Thank you for your attention

Greg Vaughan
School of Risk and Actuarial Studies
University of New South Wales

63