Concepedia

The Valuation of Options on Futures Contracts

The Journal of Finance · 1985 · 137 citations · 13 references

TL;DR

The study derives rational restrictions on American options on futures and develops valuation models for constant and stochastic interest‑rate environments. The authors construct a valuation framework that first models options under constant rates and then extends it to stochastic rates, employing numerical methods to determine optimal exercise policies. Results show that premature exercise is often optimal yet adds little value, that ignoring interest‑rate location can cause pricing errors up to ±7%, and that interest‑rate expectations are crucial for accurate valuation.

Abstract

ABSTRACT Rational restrictions are derived for the values of American options on futures contracts. For these options, the optimal policy, in general, involves premature exercise. A model is developed for valuing options on futures contracts in a constant interest rate setting. Despite the fact that premature exercise may be optimal, the value of this American feature appears to be small and a European formula due to Black serves as a useful approximation. Finally, a model is developed to value these options in a world with stochastic interest rates. It is shown that the pricing errors caused by ignoring the location of the interest rate (relative to its long‐run mean) range from −5% to 7%, when the current rate is ±200 basis points from its long‐run value. The role of interest rate expectations is, therefore, crucial to the valuation. Optimal exercise policies are found from numerical methods for both models.