The Wharton School, University of Pennsylvania and Graduate School of Business, Columbia University, respectively. We thank Mark B. Garman, M. Barry Goldman, and the referee for helpful comments, and In Joon Kim for comments and extensive computational assistance. We also thank the participants in the finance seminars at Duke University, New York University, Northwestern, M.I.T., and Wharton for their comments. The Center for the Study of Futures Markets at Columbia University supported this research.
The Valuation of Options on Futures Contracts
Article first published online: 30 APR 2012
1985 The American Finance Association
The Journal of Finance
Volume 40, Issue 5, pages 1319–1340, December 1985
How to Cite
RAMASWAMY, K. and SUNDARESAN, S. M. (1985), The Valuation of Options on Futures Contracts. The Journal of Finance, 40: 1319–1340. doi: 10.1111/j.1540-6261.1985.tb02385.x
- Issue published online: 30 APR 2012
- Article first published online: 30 APR 2012
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.