VOLUME 1, NUMBER 24/August 21, 1995
***************************************************************** DERIVATIVES 'R US is a weekly non-profit publication on the Internet user group misc.invest.futures that provides a simple non-technical treatment of various topics in derivatives. DRU is written by Don M. Chance, Professor of Finance at the Center for the Study of Futures and Options Markets at Virginia Tech. He can be contacted at dmc @ vt.edu or by phone at 540-231-5061 or fax at 540-231-4487. DRU is for educational purposes only and does not provide trading advice. Back issues of DRU available by anonymous ftp from fbox.vt.edu/filebox/business/finance/dmc/DRU or can be accessed using a Web browser at http://fbox.vt.edu:10021/business/finance/dmc/DRU. The file contents.txt can be viewed to see a list of old filenames and topics available for reading or downloading. *****************************************************************
DELIVERY OPTIONS
Options are all around us and some are almost camouflaged. For example, there are options on the futures exchange and I'm not talking about options on futures. I'm talking about delivery options. Certain futures contracts contain quirky features that can be viewed as options, and which indeed have value the same way an option does.
As is well known, many futures contracts permit delivery of any of several grades of a commodity. For example, the NYMEX Light Crude Oil contract permits delivery of the following oils: west Texas intermediate, mid-continent sweet, low sweet mix, New Mexico sweet, north Texas sweet and several more. The CBOT Treasury bond contract permits delivery of any Treasury bond that has at least fifteen years to go before delivery or its first call date. The right to decide which grade of oil or Treasury bond to deliver is held by the short. He will choose the cheapest one to deliver but as conditions change, the cheapest one to deliver may change too. This right is known as the "quality option." At any time up to delivery, the short can make the decision of which asset to deliver.
The quality option will have value if there is any possibility that the cheapest grade to deliver will change. Since there is always that possibility, the option will always have at least a small value.
Where does that value show up? The price of the contract will be lower by the amount of the value of that option. Consider two contracts, otherwise identical except that one contract specifies delivery of only one grade of the asset and the other allows the short to choose from among several deliverable grades. If the short sells the second contract, he'll receive a lower price to compensate the long for the option granted to the short.
Some contracts also contain a "location option," which is the right to choose where delivery is made (wheat for example in Chicago or Toledo). This option, however, is functionally equivalent to a quality option because the same commodity delivered in two places can simply be viewed as slightly different grades of the basic commodity.
A second class of delivery options is the "timing option." The timing option actually consists of several variations. One well-known timing option is the wild card option, which exists in the T-bond and S&P markets. In the T-bond market the futures contract stops trading at 2:00 p.m. Chicago time. The cash market for T-bonds continues to trade until as late as any dealer will make a market, which is usually about three more hours. So during that period, the futures market is closed, yet the cash market is open. Someone who is short the T-bond contract in the delivery month can take advantage of the possibility of a drop in the cash price during that time, all the while his futures contract delivery price is set at the 2:00 p.m. settlement price. To do that the short needs to hold a tailed position, meaning a hedged position of long T-bonds and short futures, but not in equal amounts. The number of T-bonds needs to be less than the required number for delivery, which creates a so-called "tail" that can be purchased at a potentially attractive price if the cash market declines.
Without getting into all of the technical aspects of this play, let us just note that the wild card trader can potentially earn significant profits. The potential is greatest when there is a signficant announcement made in the late afternoon, as is frequently the case with many major announcements. However, the futures price will reflect the value of that option by being lower at the close on any day in which such an option exists.
Another type of timing option is the end-of-month option. Some contracts permit delivery any business day of the month but their final day of trading is usually during the third week. Thus, once the contract has traded for its last day, the final settlement price is fixed. A trader can put on a tailed hedge position and wait on the possibility that during that last week, the cash price of the bonds will fall. Once again, the contract price will reflect the value of this option.
Another type of timing option comes from the right to make delivery any business day of the month. If the yield on the asset exceeds the storage and interest cost, the trader delivers early in the month. If the storage and interest costs exceed the yield, the trader delivers late in the month. Once again, however, the contract price will be lower to reflect the value of this option.
Unfortunately most of the contracts that have one option also have more than one. Separating the different values is quite difficult but the subject has been studied extensively. The value of the quality option is estimated as quite small, probably less than 1-2 % of the contract price three months prior to delivery. However, a few cases have uncovered higher quality option values.
Most importantly, however, delivery options can have a significant effect on the success or failure of a contract. They should be incorporated into or at least considered when developing hedge ratios and pricing models. Actually doing this, however, can be quite difficult. For the typical futures market participant, the key point is that contract prices are not all what they seem and activity in the delivery month can be greatly influenced by the presence of these options. The traditional futures pricing model based on the cost of carry does not fully reflect the economic factors that determine a futures contract's price.
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DERIVATIVES QUOTE FOR THE WEEK
"One day a guy lost it on the floor and started screaming about Jesus and the money changers. They had to take him away."
William Greenspan, stock index futures trader Quoted in the Wall Street Journal, March 19, 1993, p. A1
(Was that Jimmy Swaggert at the Merc that day?)