Remarks on Asian Option Pricing
• Asian option pricing is an active research area.
• The above algorithm overestimates the “true” value.a
• To guarantee convergence, k needs to grow with n at least.b
• There is a convergent approximation algorithm that does away with interpolation with a running time ofc
aDai (B82506025, R86526008, D8852600), G. Huang (F83506075), &
bDai (B82506025, R86526008, D8852600), G. Huang (F83506075), &
cDai (B82506025, R86526008, D8852600) & Lyuu (2002, 2004).
Remarks on Asian Option Pricing (continued)
• There is an O(kn2)-time algorithm with an error bound of O(Xn/k) from the naive O(2n)-time binomial tree algorithm in the case of European Asian options.a
– k can be varied for trade-oﬀ between time and accuracy.
– If we pick k = O(n2), then the error is O(1/n), and the running time is O(n4).
aAingworth, Motwani (1962–2009), & Oldham (2000).
Remarks on Asian Option Pricing (continued)
• Another approximation algorithm reduces the error to O(X√
– It varies the number of buckets per node.
– If we pick k = O(n), the error is O(n−0.5).
– If we pick k = O(n1.5), then the error is O(1/n), and the running time is O(n3.5).
• Under “reasonable assumptions,” an O(n2)-time algorithm with an error bound of O(1/n) exists.b
aDai (B82506025, R86526008, D8852600), G. Huang (F83506075), &
bHsu (R7526001, D89922012) & Lyuu (2004).
Remarks on Asian Option Pricing (concluded)
• The basic idea is a nonuniform allocation of running averages instead of a uniform k.
• It strikes a tight balance between error and complexity.
0 20 40
0 100 200 300 400
A Grand Comparisona
aHsu (R7526001, D89922012) & Lyuu (2004); J. E. Zhang (2001,2003);
K. Chen (R92723061) & Lyuu (2006).
X σ r Exact AA2 AA3 Hsu-Lyuu Chen-Lyuu 95 0.05 0.05 7.1777275 7.1777244 7.1777279 7.178812 7.177726
100 2.7161745 2.7161755 2.7161744 2.715613 2.716168
105 0.3372614 0.3372601 0.3372614 0.338863 0.337231
95 0.09 8.8088392 8.8088441 8.8088397 8.808717 8.808839
100 4.3082350 4.3082253 4.3082331 4.309247 4.308231
105 0.9583841 0.9583838 0.9583841 0.960068 0.958331
95 0.15 11.0940944 11.0940964 11.0940943 11.093903 11.094094
100 6.7943550 6.7943510 6.7943553 6.795678 6.794354
105 2.7444531 2.7444538 2.7444531 2.743798 2.744406
90 0.10 0.05 11.9510927 11.9509331 11.9510871 11.951610 11.951076
100 3.6413864 3.6414032 3.6413875 3.642325 3.641344
110 0.3312030 0.3312563 0.3311968 0.331348 0.331074
90 0.09 13.3851974 13.3851165 13.3852048 13.385563 13.385190
100 4.9151167 4.9151388 4.9151177 4.914254 4.915075
110 0.6302713 0.6302538 0.6302717 0.629843 0.630064
90 0.15 15.3987687 15.3988062 15.3987860 15.398885 15.398767
100 7.0277081 7.0276544 7.0277022 7.027385 7.027678
110 1.4136149 1.4136013 1.4136161 1.414953 1.413286
A Grand Comparison (concluded)
X σ r Exact AA2 AA3 Hsu-Lyuu Chen-Lyuu
90 0.20 0.05 12.5959916 12.5957894 12.5959304 12.596052 12.595602
100 5.7630881 5.7631987 5.7631187 5.763664 5.762708
110 1.9898945 1.9894855 1.9899382 1.989962 1.989242
90 0.09 13.8314996 13.8307782 13.8313482 13.831604 13.831220
100 6.7773481 6.7775756 6.7773833 6.777748 6.776999
110 2.5462209 2.5459150 2.5462598 2.546397 2.545459
90 0.15 15.6417575 15.6401370 15.6414533 15.641911 15.641598
100 8.4088330 8.4091957 8.4088744 8.408966 8.408519
110 3.5556100 3.5554997 3.5556415 3.556094 3.554687
90 0.30 0.05 13.9538233 13.9555691 13.9540973 13.953937 13.952421
100 7.9456288 7.9459286 7.9458549 7.945918 7.944357
110 4.0717942 4.0702869 4.0720881 4.071945 4.070115
90 0.09 14.9839595 14.9854235 14.9841522 14.984037 14.982782
100 8.8287588 8.8294164 8.8289978 8.829033 8.827548
110 4.6967089 4.6956764 4.6969698 4.696895 4.694902
90 0.15 16.5129113 16.5133090 16.5128376 16.512963 16.512024 100 10.2098305 10.2110681 10.2101058 10.210039 10.208724
110 5.7301225 5.7296982 5.7303567 5.730357 5.728161
Forwards, Futures, Futures Options, Swaps
Summon the nations to come to the trial.
Which of their gods can predict the future?
— Isaiah 43:9
The sure fun of the evening outweighed the uncertain treasure[.]
— Mark Twain (1835–1910), The Adventures of Tom Sawyer
• r will denote the riskless interest rate.
• The current time is t.
• The maturity date is T .
• The remaining time to maturity is τ = T − t (years).Δ
• The spot price is S.
• The spot price at maturity is ST.
• The delivery price is X.
• The forward or futures price is F for a newly written contract.
• The value of the contract is f.
• A price with a subscript t usually refers to the price at time t.
• Continuous compounding will be assumed.
• Long forward contracts are for the purchase of the
underlying asset for a certain delivery price on a speciﬁc time.
– Foreign currencies, bonds, corn, etc.
• Ideal for hedging purposes.
• A farmer enters into a forward contract with a food
processor to deliver 100,000 bushels of corn for $2.5 per bushel on September 27, 1995.a
• The farmer is assured of a buyer at an acceptable price.
• The processor knows the cost of corn in advance.
Forward Contracts (concluded)
• A forward agreement limits both risk and rewards.
– If the spot price of corn rises on the delivery date, the farmer will miss the opportunity of extra proﬁts.
– If the price declines, the processor will be paying more than it would.
• Either side has an incentive to default.
• Other problems: The food processor may go bankrupt, the farmer can go bust, the farmer might not be able to harvest 100,000 bushels of corn because of bad weather, the cost of growing corn may skyrocket, etc.
Spot and Forward Exchange Rates
• Let S denote the spot exchange rate.
• Let F denote the forward exchange rate one year from now (both in domestic/foreign terms).
• rf denotes the annual interest rate of the foreign currency.
• r denotes the annual interest rate of the local currency.
• Arbitrage opportunities will arise unless these four numbers satisfy an equation.
Interest Rate Paritya
S = er−rf. (56)
• A holder of the local currency can do either of:
– Lend the money in the domestic market to receive er one year from now.
– Convert local currency for foreign currency, lend for 1 year in foreign market, and convert foreign currency into local currency at the ﬁxed forward exchange rate, F , by selling forward foreign currency now.
aKeynes (1923). John Maynard Keynes (1883–1946) was one of the greatest economists in history. The parity broke down in late 2008 (Mancini-Griﬀoli & Ranaldo, 2013).
Interest Rate Parity (concluded)
• No money changes hand in entering into a forward contract.
• One unit of local currency will hence become F erf/S one year from now in the 2nd case.
• If F erf/S > er, an arbitrage proﬁt can result from
borrowing money in the domestic market and lending it in the foreign market.
• If F erf/S < er, an arbitrage proﬁt can result from
borrowing money in the foreign market and lending it in the domestic market.
• The payoﬀ of a forward contract at maturity is ST − X.
– Contrast that with call’s payoﬀ max(ST − X, 0).
• Forward contracts do not involve any initial cash ﬂow.
• The forward price F is the delivery price X which makes the forward contract zero valued.
– That is,
f = 0 when X = F.
Forward Price (continued)
0 1 2 3 · · · n
ST − X
Forward Price (concluded)
• The delivery price cannot change because it is written in the contract.
• But the forward price may change after the contract comes into existence.
• So although the value of a forward contract, f, is 0 at the outset, it will ﬂuctuate thereafter.
– This value is enhanced when the spot price climbs.
– It is depressed when the spot price declines.
• The forward price also varies with the maturity of the contract.
Forward Price: Underlying Pays No Income
Lemma 11 For a forward contract on an underlying asset providing no income,
F = Serτ. (57)
• If F > Serτ:
– Borrow S dollars for τ years.
– Buy the underlying asset.
– Short the forward contract with delivery price F .
• At maturity:
– Deliver the asset for F .
– Use Serτ to repay the loan, leaving an arbitrage proﬁt of
F − Serτ > 0.
• If F < Serτ, do the opposite.
Example: Zero-Coupon Bonds
• r is the annualized 3-month riskless interest rate.
• S is the spot price of the 6-month zero-coupon bond.
• A new 3-month forward contract on that 6-month
zero-coupon bond should command a delivery price of Ser/4.
• So if r = 6% and S = 970.87, then the delivery price is 970.87 × e0.06/4 = 985.54.
• Suppose S is the spot price of the European call that expires at some time later than T .
• A τ-year forward contract on that call commands a delivery price of Serτ.
• So it equals the future value of the Black-Scholes formula on p. 296.
Contract Value: The Underlying Pays No Income
The value of a forward contract is
f = S − Xe−rτ. (58)
• Consider a portfolio consisting of:
– One long forward contract;
– Cash amount Xe−rτ;
– One short position in the underlying asset.
Contract Value: The Underlying Pays No Income (concluded)
• The cash will grow to X at maturity, which can be used to take delivery of the forward contract.
• The delivered asset will then close out the short position.
• Since the value of the portfolio is zero at maturity, its PV must be zero.a
• So a forward contract can be replicated by a long
position in the underlying and a loan of Xe−rτ dollars.
aRecall p. 218.
Lemma 11 (p. 479) Revisited
• Set f = 0 in Eq. (58) on p. 483.
• Then X = Serτ, the forward price.
Forward Price: Underlying Pays Predictable Income
Lemma 12 For a forward contract on an underlying asset providing a predictable income with a PV of I,
F = (S − I) erτ. (59)
• If F > (S − I) erτ, borrow S dollars for τ years, buy the underlying asset, and short the forward contract with delivery price F .
• Use the income to repay part of the loan.
The Proof (concluded)
• At maturity, the asset is delivered for F , and (S − I) erτ is used to repay the remaining loan.
• That leaves an arbitrage proﬁt of
F − (S − I) erτ > 0.
• If F < (S − I) erτ, reverse the above.
• Consider a 10-month forward contract on a $50 stock.
• The stock pays a dividend of $1 every 3 months.
• The forward price is
50 − e−r3/4 − e−r6/2 − e−3×r9/4
er10×(10/12). – ri is the annualized i-month interest rate.
Underlying Pays a Continuous Dividend Yield of q
• The value of a forward contract at any time prior to T isa
f = Se−qτ − Xe−rτ. (60)
• One consequence of Eq. (60) is that the forward price is
F = Se(r−q) τ. (61)
aSee p. 160 of the textbook for proof.
Futures Contracts vs. Forward Contracts
• They are traded on a central exchange.
• A clearinghouse.
– Credit risk is minimized.
• Futures contracts are standardized instruments.
• Gains and losses are marked to market daily.
– Adjusted at the end of each trading day based on the settlement price.
Size of a Futures Contract
• The amount of the underlying asset to be delivered under the contract.
– 5,000 bushels for the corn futures on the Chicago Board of Trade (CBOT).
– One million U.S. dollars for the Eurodollar futures on the Chicago Mercantile Exchange (CME).a
• A position can be closed out (or oﬀset) by entering into a reversing trade to the original one.
• Most futures contracts are closed out in this way rather than have the underlying asset delivered.
– Forward contracts are meant for delivery.
• Price changes in the futures contract are settled daily.
• Hence the spot price rather than the initial futures price is paid on the delivery date.
• Marking to market nulliﬁes any ﬁnancial incentive for not making delivery.
– A farmer enters into a forward contract to sell a food processor 100,000 bushels of corn at $2.00 per bushel in November.
– Suppose the price of corn rises to $2.5 by November.
Daily Settlements (concluded)
– The farmer has incentive to sell his harvest in the spot market at $2.5.
– With marking to market, the farmer has transferred
$0.5 per bushel from his futures account to that of the clearinghouse by November (see p. 494).
– When the farmer makes delivery, he is paid the spot price, $2.5 per bushel.
– The farmer has little incentive to default.
– The net price remains $2.5 − 0.5 = 2 per bushel, the original delivery price.
Daily Cash Flows
• Let Fi denote the futures price at the end of day i.
• The contract’s cash ﬂow on day i is Fi − Fi−1.
• The net cash ﬂow over the life of the contract is
(F1 − F0) + (F2 − F1) + · · · + (Fn − Fn−1)
= Fn − F0 = ST − F0.
• A futures contract has the same accumulated payoﬀ ST − F0 as a forward contract.
• The actual payoﬀ may vary because of the reinvestment of daily cash ﬂows and how ST − F0 is distributed.
Daily Cash Flows (concluded)
0 1 2 3 · · · n
F1 − F0 F2 − F1 F3 − F2 · · · Fn − Fn−1
Delivery and Hedging
• Delivery ties the futures price to the spot price.
– Futures price is the delivery price that makes the futures contract zero-valued.
• On the delivery date, the settlement price of the futures contract is determined by the spot price.
• Hence, when the delivery period is reached, the futures price should be very close to the spot price.a
• Changes in futures prices usually track those in spot price, making hedging possible.
aBut since early 2006, futures for corn, wheat, and soybeans occasion- ally expired at a price much higher than that day’s spot price (Henriques, 2008).
Forward and Futures Pricesa
• Surprisingly, futures price equals forward price if interest rates are nonstochastic!b
• This result “justiﬁes” treating a futures contract as if it were a forward contract, ignoring its marking-to-market feature.
• The West Texas Intermediate (WTI) futures price was negative on April 20, 2020!c
aCox, Ingersoll, & Ross (1981).
bSee p. 164 of the textbook for proof.
cApril 21 was the last trading day for oil delivery in May to Cushing, Oklahoma.
• When interest rates are stochastic, forward and futures prices are no longer theoretically identical.
– Suppose interest rates are uncertain and futures prices move in the same direction as interest rates.
– Then futures prices will exceed forward prices.
• For short-term contracts, the diﬀerences tend to be small.
• Unless stated otherwise, assume forward and futures prices are identical.
• The underlying of a futures option is a futures contract.
• Upon exercise, the option holder takes a position in the futures contract with a futures price equal to the
option’s strike price.
– A call holder acquires a long futures position.
– A put holder acquires a short futures position.
• The futures contract is then marked to market.
• And the futures position of the two parties will be at the prevailing futures price (thus zero-valued).
Futures Options (concluded)
• It works as if the call holder received a futures contract plus cash equivalent to the prevailing futures price Ft
minus the strike price X:
Ft − X.
– This futures contract has zero value.
• It works as if the put holder sold a futures contract for X − Ft
• Similar to futures options except that what is delivered is a forward contract with a delivery price equal to the option’s strike price.
– Exercising a call forward option results in a long position in a forward contract.
– Exercising a put forward option results in a short position in a forward contract.
• Exercising a forward option incurs no immediate cash ﬂows: There is no marking to market.
• Consider a call with strike $100 and an expiration date in September.
• The underlying asset is a forward contract with a delivery date in December.
• Suppose the forward price in July is $110.
• Upon exercise, the call holder receives a forward contract with a delivery price of $100.a
• If an oﬀsetting position is then taken in the forward market,b a $10 proﬁt in December will be assured.
• A call on the futures would realize the $10 proﬁt in July.
aRecall p. 471.
bThe counterparty will pay you $110 for the underlying asset.
Some Pricing Relations
• Let delivery take place at time T , the current time be 0, and the option on the futures or forward contract have expiration date t (t ≤ T ).
• Assume a constant, positive interest rate.
• Although forward price equals futures price, a forward option does not have the same value as a futures option.
• The payoﬀs of calls at time t are, respectively,a
futures option = max(Ft − X, 0), (63) forward option = max(Ft − X, 0) e−r(T −t). (64)
Some Pricing Relations (concluded)
• A European futures option is worth the same as the corresponding European option on the underlying asset if the futures contract has the same maturity as both options.
– Futures price equals spot price at maturity.
• This conclusion is independent of the model for the spot price.
The put-call parity is slightly diﬀerent from the one in Eq. (31) on p. 225.
Theorem 13 (1) For European options on futures contracts,
C = P − (X − F ) e−rt.
(2) For European options on forward contracts, C = P − (X − F ) e−rT.
aSee Theorem 12.4.4 of the textbook for proof.
The early exercise feature is not valuable for forward options.
Theorem 14 American forward options should not be
exercised before expiration as long as the probability of their ending up out of the money is positive.
• See Theorem 12.4.5 of the textbook for proof.
Early exercise may be optimal for American futures options even if the underlying asset generates no payouts.
Theorem 15 American futures options may be exercised optimally before expiration.
• Formulas for European futures options:
C = F e−rtN (x) − Xe−rtN (x − σ√ t) P = Xe−rtN (−x + σ√
t) − F e−rtN (−x) where x =Δ ln(F/X)+(σ2/2) t
• The above formulas are related to those for options on a stock paying a continuous dividend yield.
• They are exactly Eqs. (43) on p. 326 with q set to r and S replaced by F .
aBlack (1976). It is also called the Black-76 model.
Black’s Model (concluded)
• This observation incidentally proves Theorem 15 (p. 506).
• For European forward options, just multiply the above formulas by e−r(T −t).
– Forward options diﬀer from futures options by a factor of e−r(T −t).a
aRecall Eqs. (63)–(64) on p. 503.
Binomial Model for Forward and Futures Options
• In a risk-neutral economy, futures price behaves like a stock paying a continuous dividend yield of r.
– The futures price at time 0 is (p. 479) F = SerT.
– From Lemma 9 (p. 294), the expected value of S at time Δt in a risk-neutral economy is
– So the expected futures price at time Δt is SerΔter(T −Δt) = SerT = F.
Binomial Model for Forward and Futures Options (continued)
• The above observation continues to hold even if S pays a dividend yield!a
– By Eq. (61) on p. 489, the futures price at time 0 is F = Se(r−q) T.
– From Lemma 9 (p. 294), the expected value of S at time Δt in a risk-neutral economy is
– So the expected futures price at time Δt is Se(r−q) Δte(r−q)(T −Δt) = Se(r−q) T = F.
aContributed by Mr. Liu, Yi-Wei (R02723084) on April 16, 2014.
Binomial Model for Forward and Futures Options (concluded)
• Now, under the BOPM, the risk-neutral probability for the futures price is
pf = (1Δ − d)/(u − d) by Eq. (44) on p. 328.
– The futures price moves from F to F u with
probability pf and to F d with probability 1 − pf. – Note that the original u and d are used!
• The binomial tree algorithm for forward options is identical except that Eq. (64) on p. 503 is the payoﬀ.
Spot and Futures Prices under BOPM
• The futures price is related to the spot price via F = SerT
if the underlying asset pays no dividends.a
• Recall the futures price F moves to F u with probability pf per period.
• So the stock price moves from S = F e−rT to F ue−r(T −Δt) = SuerΔt
with probability pf per period.
aRecall Lemma 11 (p. 479).
Spot and Futures Prices under BOPM (concluded)
• Similarly, the stock price moves from S = F e−rT to SderΔt
with probability 1 − pf per period.
• Note that
S(uerΔt)(derΔt) = Se2rΔt = S.
• So this binomial model for S is not the CRR tree.
• This model may not be suitable for pricing barrier options (why?).
Negative Probabilities Revisited
• As 0 < pf < 1, we have 0 < 1 − pf < 1 as well.
• The problem of negative risk-neutral probabilities is solved:
– Build the tree for the futures price F of the futures contract expiring at the same time as the option.
– Let the stock pay a continuous dividend yield of q.
– By Eq. (61) on p. 489, calculate S from F at each node via
S = F e−(r−q)(T −t).
• Swaps are agreements between two counterparties to exchange cash ﬂows in the future according to a
• There are two basic types of swaps: interest rate and currency.
• An interest rate swap occurs when two parties exchange interest payments periodically.
• Currency swaps are agreements to deliver one currency against another (our focus here).
• There are theories about why swaps exist.a
• A currency swap involves two parties to exchange cash ﬂows in diﬀerent currencies.
• Consider the following ﬁxed rates available to party A and party B in U.S. dollars and Japanese yen:
Dollars Yen A DA% YA% B DB% YB%
• Suppose A wants to take out a ﬁxed-rate loan in yen, and B wants to take out a ﬁxed-rate loan in dollars.
Currency Swaps (continued)
• A straightforward scenario is for A to borrow yen at YA% and B to borrow dollars at DB%.
• But suppose A is relatively more competitive in the dollar market than the yen market, i.e.,
YB − DB < YA − DA or YB − YA < DB − DA.
• Consider this alternative arrangement:
– A borrows dollars.
– B borrows yen.
– They enter into a currency swap with a bank (the
Currency Swaps (concluded)
• The counterparties exchange principal at the beginning and the end of the life of the swap.
• This act transforms A’s loan into a yen loan and B’s yen loan into a dollar loan.
• The total gain is ((DB − DA) − (YB − YA))%:
– The total interest rate is originally (YA + DB)%.
– The new arrangement has a smaller total rate of (DA + YB)%.
• Transactions will happen only if the gain is distributed so that the cost to each party is less than the original.
• A and B face the following borrowing rates:
A 9% 10%
B 12% 11%
• A wants to borrow yen, and B wants to borrow dollars.
• A can borrow yen directly at 10%.
• B can borrow dollars directly at 12%.
• The rate diﬀerential in dollars (3%) is diﬀerent from that in yen (1%).
• So a currency swap with a total saving of 3 − 1 = 2% is possible.
• A is relatively more competitive in the dollar market.
• B is relatively more competitive in the yen market.
• Next page shows an arrangement which is beneﬁcial to all parties involved.
– A eﬀectively borrows yen at 9.5% (lower than 10%).
– B borrows dollars at 11.5% (lower than 12%).
– The gain is 0.5% for A, 0.5% for B, and, if we treat dollars and yen identically, 1% for the bank.
Party B Bank
Dollars 9% Yen 11%