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A note on the design of commodity options contracts: A comment

✍ Scribed by Robert McDonald; Daniel Siegel

Publisher: John Wiley and Sons
Year: 1983
Tongue: English
Weight: 241 KB
Volume: 3
Category: Article
ISSN: 0270-7314
DOI: 10.1002/fut.3990030104

No coin nor oath required. For personal study only.

✦ Synopsis

n his note in the spring 1982 issue of this journal, Asay (1982) discusses the I pricing of commodity option contracts. The purpose of his note is to introduce the idea of a "futures" option, which, like a standard futures contract, requires no money up-front and is "marked to market" at the end of each trading day. His arguments about the advantages of this kind of option are quite convincing. As an introduction, Asay discusses the pricing and properties of %randard" commodity options, which require a cormnitment of funds up-front and do not provide for daily settling up. The discussion of standard commodity options is an important one in its own right, because such options exist both in Europe and in the US., and others are being proposed in this country. This note attempts to rectdy some errors in hay's discussion.

h a y discusses two kinds of "standard" contracts: a call option written on a physical commodity and a call option written on a futures contracLl hay provides formulas for each of these contracts. We show, in Section I of this comment, that the first formula is incorrect and that the second formula is correct in this case. We also discuss why divergences &om the first formula will not result in arbitrage profits, while divergences from &he second will, In Section 11, we discuss the properties of American versions of those contracts (i.e., call options which can be exercised at any time up to expiration). white Asay asserts that American call options on physical commodities will never be exercised prematurely, we show that like American calls written on futures contracts, early exercise is a possibility. Section 111 verifies hay's formula for a 'Lfutures" options using results from earlier sections.

'Presumably, by exercising the second kind of option, the owner receives the current futures price.

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