Theory of Rational Futures-Style Option Pricing

36 Pages Posted: 10 Sep 2009

See all articles by Rodolfo Oviedo

Rodolfo Oviedo

Universidad Austral; McGill University - Desautels Faculty of Management

Domingo A. Tarzia

Univ. Austral, FCE, Mathematics Department & CONICET

Date Written: September 2009

Abstract

Options on futures traded in Europe, Australia and South Africa are subject to futures-style premium posting (FSPP): the premium is not paid up front but marked to market, and the last settlement premium paid upon exercise. The previous literature has derived pricing models for such options. Only after that derivation, and using the resulting model or its assumptions, has it deducted pricing constraints like a put-call parity or the positivity of time value. Following Merton (1973), we do the reverse. First, we show the full generality of all properties found by Lieu (1990) and many other rational option-pricing constraints. In the second part of the article, we derive a binomial model not found in the literature, and give another derivation of Lieu (1990)’s model. In these derivations, we emphasize, first, the possibility of pricing an option by replicating its mark-to-market cash flows (MTM CF) rather than a final payoff and, second, the irrelevance of the interest rate process, which holds even though futures-style options generate a continuous stream of MTM CF. The irrelevance of interest rates is also true for rational option-pricing constraints.

Keywords: futures-style options, futures Merton Lieu, LIFFE, Europe Sydney Exchange, Safex constraints

JEL Classification: G12, G13

Suggested Citation

Oviedo, Rodolfo and Tarzia, Domingo A., Theory of Rational Futures-Style Option Pricing (September 2009). Available at SSRN: https://ssrn.com/abstract=1469552 or http://dx.doi.org/10.2139/ssrn.1469552

Rodolfo Oviedo (Contact Author)

Universidad Austral ( email )

Rosario, Santa Fe
Argentina
+45 9 341 345 1706 (Phone)

McGill University - Desautels Faculty of Management

Montreal, QC
Canada

Domingo A. Tarzia

Univ. Austral, FCE, Mathematics Department & CONICET ( email )

S2000FZF Rosario
Argentina
+54 341 5223001 (Fax)

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