Low Exercise Price Option

Last updated

A Low Exercise Price Option (LEPO) is an Australian Stock Exchange traded option with a low exercise price that was specifically designed to be traded on margin. It is a European style call option with a low exercise price of $0.01 and a contract size of 100 shares to be delivered on exercise.

Contents

The premium is close to the whole share price, and a trader only posts margin, not the full price. Both the buyer and the seller are margined, all positions are marked-to-market daily.

History

The Australian Stock Exchange started listing LEPO exchange traded options in 1995 to allow traders to trade underlying shares on margin. In 2018, there are 100 ASX listed companies that offer LEPO contracts.

Differences from standard options

Several important differences distinguish LEPOs from standard exchange-traded options, and these differences have important implications for the pricing of LEPO.

LEPOs may be over either shares or an index.

Pricing of Low Exercise Price Options

The current value of a contract is equal to the current price of the underlying share compounded by the risk-free interest rate, less the accumulated value of any dividends, less the exercise price of $0.01.

where:

To prove that above formula is correct, we'll calculate price using Black–Scholes formula. The Black–Scholes formula after modifications to recognize that the premium is paid at the expiry of the contract:

where:

N(d) is cumulative probability distribution function for a standard normal distribution.

For a LEPO an underlying price is very big compare to exercise price X. Because of that is very close to 1, with insignificant difference. Thus LEPO price per Black–Scholes formula (without dividend) is

and it matches our previous formula.

Related Research Articles

The Black–Scholes or Black–Scholes–Merton model is a mathematical model for the dynamics of a financial market containing derivative investment instruments. From the parabolic partial differential equation in the model, known as the Black–Scholes equation, one can deduce the Black–Scholes formula, which gives a theoretical estimate of the price of European-style options and shows that the option has a unique price given the risk of the security and its expected return. The equation and model are named after economists Fischer Black and Myron Scholes. Robert C. Merton, who first wrote an academic paper on the subject, is sometimes also credited.

<span class="mw-page-title-main">Call option</span> Contract giving a buyer the right to buy a security from the seller at a set price

In finance, a call option, often simply labeled a "call", is a contract between the buyer and the seller of the call option to exchange a security at a set price. The buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument from the seller of the option at or before a certain time for a certain price. This effectively gives the owner a long position in the given asset. The seller is obliged to sell the commodity or financial instrument to the buyer if the buyer so decides. This effectively gives the seller a short position in the given asset. The buyer pays a fee for this right. The term "call" comes from the fact that the owner has the right to "call the stock away" from the seller.

In finance, a put or put option is a derivative instrument in financial markets that gives the holder the right to sell an asset, at a specified price, by a specified date to the writer of the put. The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock. The term "put" comes from the fact that the owner has the right to "put up for sale" the stock or index.

In financial mathematics, the put–call parity defines a relationship between the price of a European call option and European put option, both with the identical strike price and expiry, namely that a portfolio of a long call option and a short put option is equivalent to a single forward contract at this strike price and expiry. This is because if the price at expiry is above the strike price, the call will be exercised, while if it is below, the put will be exercised, and thus in either case one unit of the asset will be purchased for the strike price, exactly as in a forward contract.

<span class="mw-page-title-main">Warrant (finance)</span> Security that entitles the holder to buy stock

In finance, a warrant is a security that entitles the holder to buy or sell stock, typically the stock of the issuing company, at a fixed price called the exercise price.

In finance, the style or family of an option is the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American (style) options. These options—as well as others where the payoff is calculated similarly—are referred to as "vanilla options". Options where the payoff is calculated differently are categorized as "exotic options". Exotic options can pose challenging problems in valuation and hedging.

The Black model is a variant of the Black–Scholes option pricing model. Its primary applications are for pricing options on future contracts, bond options, interest rate cap and floors, and swaptions. It was first presented in a paper written by Fischer Black in 1976.

In finance, the binomial options pricing model (BOPM) provides a generalizable numerical method for the valuation of options. Essentially, the model uses a "discrete-time" model of the varying price over time of the underlying financial instrument, addressing cases where the closed-form Black–Scholes formula is wanting.

In mathematical finance, the Greeks are the quantities representing the sensitivity of the price of a derivative instrument such as an option to changes in one or more underlying parameters on which the value of an instrument or portfolio of financial instruments is dependent. The name is used because the most common of these sensitivities are denoted by Greek letters. Collectively these have also been called the risk sensitivities, risk measures or hedge parameters.

In finance, moneyness is the relative position of the current price of an underlying asset with respect to the strike price of a derivative, most commonly a call option or a put option. Moneyness is firstly a three-fold classification:

In finance, the time value (TV) of an option is the premium a rational investor would pay over its current exercise value, based on the probability it will increase in value before expiry. For an American option this value is always greater than zero in a fair market, thus an option is always worth more than its current exercise value. As an option can be thought of as 'price insurance', TV can be thought of as the risk premium the option seller charges the buyer—the higher the expected risk, the higher the premium. Conversely, TV can be thought of as the price an investor is willing to pay for potential upside.

An Asian option is a special type of option contract. For Asian options, the payoff is determined by the average underlying price over some pre-set period of time. This is different from the case of the usual European option and American option, where the payoff of the option contract depends on the price of the underlying instrument at exercise; Asian options are thus one of the basic forms of exotic options.

Lookback options, in the terminology of finance, are a type of exotic option with path dependency, among many other kind of options. The payoff depends on the optimal underlying asset's price occurring over the life of the option. The option allows the holder to "look back" over time to determine the payoff. There exist two kinds of lookback options: with floating strike and with fixed strike.

Rational pricing is the assumption in financial economics that asset prices – and hence asset pricing models – will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.

In finance, a foreign exchange option is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. See Foreign exchange derivative.

In finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option. Options are typically acquired by purchase, as a form of compensation, or as part of a complex financial transaction. Thus, they are also a form of asset and have a valuation that may depend on a complex relationship between underlying asset price, time until expiration, market volatility, the risk-free rate of interest, and the strike price of the option. Options may be traded between private parties in over-the-counter (OTC) transactions, or they may be exchange-traded in live, public markets in the form of standardized contracts.

A local volatility model, in mathematical finance and financial engineering, is an option pricing model that treats volatility as a function of both the current asset level and of time . As such, it is a generalisation of the Black–Scholes model, where the volatility is a constant. Local volatility models are often compared with stochastic volatility models, where the instantaneous volatility is not just a function of the asset level but depends also on a new "global" randomness coming from an additional random component.

<span class="mw-page-title-main">Black–Scholes equation</span> Partial differential equation in mathematical finance

In mathematical finance, the Black–Scholes equation, also called the Black–Scholes–Merton equation, is a partial differential equation (PDE) governing the price evolution of derivatives under the Black–Scholes model. Broadly speaking, the term may refer to a similar PDE that can be derived for a variety of options, or more generally, derivatives.

In mathematical finance, Margrabe's formula is an option pricing formula applicable to an option to exchange one risky asset for another risky asset at maturity. It was derived by William Margrabe in 1978. Margrabe's paper has been cited by over 2000 subsequent articles.

In finance, Black's approximation is an approximate method for computing the value of an American call option on a stock paying a single dividend. It was described by Fischer Black in 1975.

References

  1. Stephen A. Easton, Sean M. Pinder “The Pricing of Low Exercise Price Options” https://web.archive.org/web/20110303213813/http://www.agsm.edu.au/eajm/9812/pdf/easton.pdf
  2. Low Exercise Price Options Explanatory Booklet, ASX https://web.archive.org/web/20100917192520/http://asx.com.au/products/pdf/UnderstandingLEPOs.pdf