Pag 15 OPTIONS AND FUTURES: A TECHNICAL APPRAISAL by David J.S. Rutldg Papr prsntd to Sminar on Trading in Options: Opportunitis in th Intrnational Markt sponsord by Th Sydny Stock Exchang and Th Scuritis Institut of Australia. Sydny, April 1985. Th past fiftn yars hav sn a rmarkabl xpansion in th xtnt and dpth of financial markts gnrally and nowhr is this mor clarly dmonstratd than in th aras of options and futurs. Ths dvlopmnts rflct th gradual drgulation of many financial markts during this priod togthr with a trnd towards a mor fr markt orintd approach to conomic policy. As a rsult crtain conomic variabls such as intrst rats and forign xchang rats hav bcom mor volatil, crating nw trading opportunitis and a dmand for nw risk managmnt vhicls. Whras fiftn yars ago options and futurs wr sotric and spcialisd instrumnts whos scrts wr known only to a slct fw on th priphry of th financial community, thy ar today an intgral componnt of our financial markts. Whras fiftn yars ago bank and institutional participation in ths markts was only th subjct of brochurs producd sanguinly in anticipation by xchangs, and articls writtn nthusiastically by acadmics, today's rality is that banks hav futurs and/or options divisions or subsidiaris which, not uncommonly, ar mmbrs of organisd xchangs on which ths instrumnts ar tradd; and institutions, whil not as committd as bankrs, ar frqunt participants in ths markts. A furthr fatur of this dvlopmnt is its intrnational charactr. Financial futurs and options hav sprung up in a divrsity of financial cntrs around th world. Whil thr is a crtain amount of mimicry about this phnomnon, it rmains th cas that, as intrnational financial markts hav bcom mor intgratd, succssful innovations in on cntr ar found to mt a nd in othr cntrs. This dvlopmnt has rachd th stag whr intrnational linkags btwn options and futurs markts ar now bing stablishd (of which th xisting link btwn th Sydny Stock Exchang and th Intrnational Options Markt in Amstrdam, Montral and Vancouvr, and th imminnt link btwn th Sydny Futurs Exchang and Comx ar two outstanding xampls). Ths linkags hav highlightd th apparnt similaritis btwn options and futurs and hav rinforcd th viw of many popl that options markts and futurs markts ar ssntially in comptition with ach othr. Anothr rcnt dvlopmnt is th braking down of what had onc bn sn to b natural dividing lins btwn options markts and futurs markts. This bgan with th intrusion by futurs markts into th stock indx ara and this has bn followd by th dvlopmnt of options markts on physical currncy, bullion and dbt instrumnts, and by th introduction at futurs xchangs of tradd options on futurs. Th objctivs of this papr ar thrfold. Firstly to provid an ovrviw of th instrumnts that prsntly xist or whos introduction is imminnt. Scondly to draw out th fundamntal diffrncs which xist btwn th mor important of ths instrumnts. Finally to commnt brifly on th xtnt to which ths various instrumnts compt with or complmnt ach othr. Th papr will focus on options and futurs basd upon financial instrumnts, broadly dfind to includ currncis, dbt and quity instrumnts and prcious mtals. This is not to say that th issus to b addrssd do not rlat to othr aras: thr ar for xampl, a numbr of intrsting and important qustions in th ara of agricultural commodity options vrsus agricultural commodity futurs. Howvr, thr ar fw, if any, fundamntal issus which aris in th financial instrumnts ara which do not hav broadr application. Th trm "option" in this papr will b usd to man xchang tradd put or call options on financial instrumnts. In particular it will not rfr to company options or warrants, which ar option instrumnts JASSA/1985, No. 2 (July)
IASSA/1985. No. 2 (/ulvl Pag 16 Th Scuritis Institut Journal writtn on th capital of a corporation and issud by that corporation for th purpos of raising additional funds. Th Evolution of Options & Futurs on Financial Instrumnts It is tmpting for studnts of today's dvlopmnts in options and futurs on financial instrumnts to gt carrid away with th ingnious faturs of th nw instrumnts and to ovrlook th long history of both classs of markts. In fact today's markts ar th rsult of a procss of financial gntic slction which is almost crtainly not yt finishd. It is appropriat thrfor to considr brifly th history of ths markts in ordr to bttr apprciat th rlationships btwn thm. Both futurs markts and option markts ar drivativ markts dpndant upon undrlying primary markts. Thy both bring a tim dimnsion to th procss of pric dtrmination which maks thm potntially usful vhicls for hdging or risk managmnt. But th outstanding institutional fatur which thy hav in common and which is fundamntal to thir succss as trading instrumnts is th claring hous. Many financial institutions hav claring houss of on form or anothr but th uniqu charactristic of th options/futurs claring hous structur is that th claring hous intrposs itslf btwn th partis to a contract and ffctivly thrby assums principal positions itslf. By this procss transactions costs in options and futurs markts ar rducd considrably by comparison to thos in principal markts and spculativ participation is gratly nhancd. Th claring hous systm that xists today in both futurs and tradd options is ssntially that which volvd in th Chicago grain markts in th middl of last cntury. Whil ths markts wr originally principal to principal markts, by about 1860 a claring hous systm had dvlopd which cam to b th principal fatur of today's futurs markts. Whil option markts do not hav a long a history as principal to principal markts as do th antcdnts of futurs makts, such institutional arrangmnts crtainly wll pr-dat th dvlopmnt of tradd option markts. In th 1950's and 1960's for xampl, an activ principal to principal markt in common stock puts and calls opratd btwn option dalrs in Nw York, although this was notaffliatd with th Nw York Stock Exchang. Trading in ths instrumnts on a principal to principal basis was also a fatur of activity on th London Stock Exchang at this tim. But it was th futurs-styl claring hous which nabld options markts to volv to thir nxt stag of dvlopmnt, th tradd options markt. It was no accidnt that th first and still th most succssful of th tradd stock option markts, th Chicago Board Options Exchang (CBOE) was foundd in Chicago, th futurs capital of th world, rathr than in Nw York or London, th homs of th largst stock xchangs. Th founding of CBOE in 1973 was th turning point in th dvlopmnt of option markts. Similarly structurd option markts on common stock commncd soon thraftr in London, Amstrdam, Sydny and lswhr in North Amrica. During th 1970's, whil th stock option markts wr going through thir infancis with varying dgrs of robustnss, th futurs markts wr thmslvs undrgoing a chang of dirction which would ultimatly turn thm towards th nw option markts. This was th dvlopmnt of financial futurs, first in th form of currncy futurs launchd in Chicago in th arly 1970's, and intrst rat futurs which followd in th mid 1970's. Th ncroachmnt of futurs into financial markts was both inxorabl and invitabl, givn th drgulation thn taking plac in th financial sctor, onc th futurs boffins had mastrd th tchniqu of adapting th traditional futurs contract to apply to financial instrumnts rathr than primary commoditis. Th roll call of financial futurs contracts is imprssiv, vn in rtrospct-currncis, mortgag crtificats, U.S. govrnmnt scurits, commrcial papr, bank crtificats of dposit, urodollar tim dposits, and many mor outsid th U.S. It was clar by th lat 1970's that th introduction of quity basd futurs contracts was only a mattr of tim. Th procss of convrgnc of futurs and options markts was continuing on th options sid too, with th dvlomnt of currncy options in th Philadlphia Stock Exchang and bullion options on th Intrnational Options Markt. With th dvlopmnt of stock indx futurs contracts on futurs xchangs and tradd options on th sam stock indics on options xchangs in th arly 1980's th markts cam into virtual had-on comptition, a stat of affairs which has only bn xacrbatd by th mor rcnt introduction by futurs xchangs of tradd options on futurs contracts. In Sydny w s a microcosm of ths intrnational dvlopmnts. Th Sydny Stock Exchang was on of
Options and Futurs: A. Tchnical Appraisal Pag 17 th first to follow CBOE with th introduction of tradd puts and calls on individual stocks. In conjunction with th Intrnational Options Markts it now offrs bullion options and will, I undrstand, shortly offr currncy options. I undrstand also that, subjct to rgulatory approval, th Sydny Stock Exchang intnds to list physical stock indx options. At th sam tim th Sydny Futurs Exchang lists futurs contracts on currncis, bullion, intrst rat and stock indics. It intnds shortly to list tradd options on ths futurs contracts. Dtails of th Instrumnts It is clar thn that th potntial participant in ths markts facs a bwildring array of instrumnts. Laving asid for th momnt th furthr complication of diffring contract siz and transactions costs structurs, h may at last b rquird to choos btwn a futurs contract, an "option on physicals" contract and an "option on futurs" contract, in ach cas on th sam undrlying asst or instrumnt. Initially it would b appropriat to dfin what is mant by ach of ths trms: A futurs contract is an agrmnt by which th sllr is obligd to dlivr, and th buyr obligd to accpt dlivry of, a spcifid asst at a pric at th tim of th agrmnt. Altrnativly, as in th cas of svral important financial futurs contracts, th obligations on th partis may b to sttl in cash at a cash sttlmnt pric dtrmind in an agrd fashion. An" option on physicals" is an agrmnt by which th buyr acquirs th right to purchas or sll, dpnding on whthr th option is a call or a put, a spcifid asst at a fixd pric prior to a fixd futur dat; and by which th sllr ntrs into a corrsponding contingnt obligation. Altrnativly, as in options on stock indics, th buyr's right and th sllr's contingnt obligation, may b to sttl in cash at a cash sttlmnt pric dtrmind in an agrd fashion. An "option on futurs" is an agrmnt by which th buyr acquirs th right to assum a long or a short futurs position (dpnding on whthr th option is a call or a put) at a fixd pric prior to a fixd dat; and by which th sllr ntrs into a corrsponding contingnt obligation. In th past it has bn common to dscrib options as "limitd risk" instrumnts in comparison to futurs, by virtu of th fact that th maximum loss on a bought option position is th prmium paid to th sllr at th tim th option is tradd. This fatur of options maks thm particularly attraciv to th public or spculativ participant, spcially in comparison to futurs whr no corrsponding maximum loss can b stablishd in advanc. Howvr it ought to b mntiond that this fatur dpnds solly upon th prmium bing paid in full by th buyr of th option. Thr is no rason why this should ncssarily b th cas; th prmium could b lvragd and th buyr subjct to margin calls in th sam way as a futurs tradr. Th advantag of structuring an option contract in this fashion is that th costs of participation on th bought sid ar rducd and hnc that liquidity is nhancd. Th primary disadvantag is that th sllr dos not rciv th prmium at th tim of trad. Th options on futurs contracts du to b launchd on th Sydny Futurs Exchang nxt month will includ this lvraging of prmium fatur as will similar contracts to b introducd on th London Intrnational Financial Futurs Exchang in Jun. Although its introduction is to b in th contxt of options on futurs thr is no rason why it could not b applid to options on physicals. In any vnt th "lvragd vrsus unlvragd prmium" qustion rprsnts yt anothr wrinkl to b takn into account in comparing various instrumnts. Th fundamntal diffrnc btwn options and futurs has to do with thir rspctiv potntial profit profils. A futurs position is xposd to a pric fluctuation in dirct proportion to that fluctuation rgardlss of its magnitud or dirction. On th othr hand, th buyr of an option is xposd to pric fluctuation in th undrlying instrumnt, and in dirct proportion to that fluctuation, but th xtnt of that xposur is limitd on th downsid by th prmium (this is tru for both lvragd and unlvragd option structurs). Th sllr of an option is xposd to pric fluctuation in th undrlying instrumnt but th potntial profit on his position is constraind to b no gratr than th option prmium. Th ffct is that an options tradr is ffctivly unbundling his upsid risk from his downsid risk, at last in comparison to taking a position in th undrlying instrumnt. Th unbundld risks can in fact b rconstitutd by an appropriat combination of option positions. Intuitivly, for xampl, th purchas of a call and th sal of a put at th sam strik or xrcis pric would appar to b quivalnt to th purchas of th undrlying instrumnt at that pric. Mor formally, th )ASSA/1985, No. 2 (July)
JA<:<:A/1QRc; /\Jn 7 t/11/vl Pag 18 Th Scuritis Institut Journal prics of puts, calls, th undrlying instrumnt and th risk fr intrst rat ar rlatd in such a way that th valus of any thr dtrmin th valu of th fourth. This is th so-calld put/call parity rsult of th acadmic litratur. In th contxt of options on futurs this rsult mans that a futurs position can b synthsisd from an appropriat combination of puts and calls on futurs. Th rvrs is not tru: no combination of futurs positions will simulat an option position. Actually a futurs position in combination with a stop loss ordr will simulat an options position; providd th stop loss is proprly xcutd. In volatil markts, howvr, on can hardly rly on stop loss ordrs for protction. Th fact that option contracts can b rbundld to ffctivly crat a position in th undrlying instrumnt, whras a futurs contract cannot b unbundld into its componnt option positions suggsts that options ar mor vrsatil instrumnts than futurs. This lads us to a comparison of th various instrumnts. Comparison of th Instrumnts In comparing options and futurs as trading vhicls on must hav rgard to th typ of tradr on has in mind. For th public tradr or spculator th thr instrumnts undr considration appar to b vry similar. For xampl, such a tradr who wishd to tak a position in gold or in a currncy could do so by taking a position in options on physicals, in futurs or in options on futurs. In ach cas h would acquir a lvragd xposur to pric movmnt at rlativly low transaction cost. Th rlvant factors in choosing among th altrnativs includ: contract siz: th largr th contract th gratr th tradr's xposur to pric fluctuation. This is tru of both options and futurs - vn in an unlvrc.gd option contract th prmium may b too grat rlativ to th tradr's capital if th contract siz is too grat. out of pockt transaction costs. markt liquidity: spculativ tradrs hav a grat avrsion, and rightly so, to bing unabl to trad out of position onc stablishd. Thy will almost always, for xampl, prfr a mor liquid largr contract siz markt ovr an illiquid smallr contract, vn if th smallr contract would, on contract siz critria alon, b th mor appropriat. Th ovrriding considration for th spculativ tradr, particularly th smallr spculator, is th xtnt of xposur associatd with ach instrumnt and, in this rspct, th options contracts hav a clar advantag. By buying an option th spculator or invstor can participat in favourabl pric movmnts but limit losss in th vnt of unfavourabl pric movmnts to th option prmium. It should prhaps b notd that. in practic this advantag of options may b offst by th fact that put option markts ar frquntly illiquid and difficult to trad in. As a rsult a tradr who wishs to tak a short position in th undrlying instrumnt may hav littl choic but to sll futurs or sll call options, in which cas th downsid risk is not limitd. A comparision of th trading fficacy of th various instrumnts as hdging vhicls is rathr mor complx. It firstly rquirs clarrification of what is mant by th trm "hdging". Rathr than attmpting a watrtight dfinition of hdging th following provids two xampls which dscrib a grat dal of hdging activity in practic. Th first is so calld "anticipatory hdging" in which a hdg position is adoptd in anticipation of a physical markt transaction to b undrtakn at a latr dat. For xampl a shar portfolio managr may wish to protct futur shar purchass, bing concrnd ovr th possibility of a markt upturn in th intrvning priod; an xportr may wish to covr futur forign currncy rcivabls against an apprciation in th domstic currncy. For hdging of this typ futurs rprsnt a suprior instrumnt to options, bcaus th hdg transaction is a substitut for th physical markt transaction to b undrtakn at a latr tim and bcaus futurs simulat th physical transaction bttr than options. Th scond class of hdging transaction to b mntiond is what might b calld "invntory hdging". It involvs th sal of a call option or futur (or possibly th purchas of a put option) against an invntory of scuritis or othr instrumnts. Such a hdg may b undrtakn for protction against a pric dclin (as in th cas of th simpl sal offuturs or so calld "dlta hdging" in options) or to profit from pric rlationships, (as in th cas of buying and writing options or "cash and carry" oprations in bullion and intrst rat futurs). It is lss asy to rank options and futurs as instrumnts for hdging in this
Options and Futurs: A Tchnical Appraisal Pag 19 cas than it is in th cas of anticipatory hdging. In th invntory hdg cas ithr instrumnt may b usd, with th choic dpnding as much as anything ls on how closly th hdg instrumnt rsmbls th composition of th invntory to.b hdgd. Finally, on typ of hdging activity for which th option contract is clarly suprior to futurs dsrvs mj;ltion. This is whr th physical markt position to b hdgd is in th form of a contingnt transaction; for xampl participants in a comptitiv tndr may wish to hdg an intrst rat or currncy risk, but only if thir bid or offr is succssful. Such situations ar tailor mad for hdging via options. Th forgoing brif comparison of th altrnativ instrumnts for hdging purposs has bn cast in trms of options vrsus futurs and as such has glossd ovr th distinction btwn options on physicals and options on futurs. Whil this distinction may b of som thortical importanc, I suspct that its significanc in trms of practical hdging dcisions is limitd to bing a rlativly minor componnt of basis risk. Th prcding discussion also ignors such mattrs as transactions cost and markt liquidity, which ar no lss important to th hdgr than to th spculator. Ovrall, in comparing th instrumnts for both hdgrs and spculators, th rathr unxciting conclusion mrgs that no on instrumnt or markt dominats th othr. This is hardly surprising as th prsnt divrsity would prsumably not hav com about unlss th various markts and instrumnts ach had somthing to offr potntial usrs. This is not to say that thr is not comptition amongst ths altrnativs with th most blatant xampls bing options on physicals and options on futurs, ach on th sam undrlying instrumnt. In such cass, unlss th markts ar diffrntiatd by somthing lik contract siz, it is virtually impossibl to choos btwn thm. Othrwis it sms likly that th divrsity of markts and instrumnts will prsist, with thir rlativ succss dpnding upon th xtnt of thir rspctiv natural clintl as wll as mor lusiv factors such as accidnts of histmy which oftn sm to dictat that all important quantity markt liquidity. Importantly also this ntwork of diffrnt markts and instrumnts on similar assts will b linkd by arbitrag activitis which will hlp transfr th liquidity of on markt to th othr. Th following rmarks ar mad as obsrvations. concluding Firstly, th obsrvations of this papr hav assumd away such things as rgulatory activitis by govrnmnt. If govrnmnts fail to apply an vn rgulatory hand to altrnativ markts th conclusions suggstd abov may not hold tru. Th sam would apply if diffrnt countris rgulat ths markts in substantially diffrnt fashions. Scondly, for all th diffrncs, subtl and othrwis, that xist btwn options on physicals, futurs and options on futurs, thy shar an ovr-riding commonality in that thy ar all instrumnts which facilitat th harnssing of risk capital in a way which nabls firms, corporations and institutions who ar xposd to particular pric, intrst rat and currncy risks to bttr manag ths xposurs. If Australia's options and futurs markts ar to dvlop furthr it is clar that thy will hav to attract additional risk capital. If, as is prsntly th cas, our tax systm can ncourag risk capital to particular aras of conomic activity, th qustion might b addrssd as to whthr considration ought not b givn, as part of th currnt taxation rviw, to th important potntial rol of ths markts in th conomy. )ASSA/1985, No. 2 (July)