Low Exercise Price Option
A Low Exercise Price Option (LEPO) is an
to be delivered on exercise.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. LEPOs work like a futures contract.
History
The
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.
- The buyer of a LEPO does not pay the full amount of the premium upfront.
- Both buyer and seller of LEPOs involve ongoing margin payments.
- The buyer of a LEPO does not receive voting rightson the underlying shares until the shares are transferred after exercise.
- LEPOs are only available as call options.
- LEPOs have a very low exercise price and a high premium close to the initial value of the underlying shares.
- LEPOs have only one exercise price per expiry month.
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
where:
- = price of LEPO contract entered into at time 0 for delivery at time 1;
- = price of underlying share at time 0;
- r = risk-free rate of return;
- n = number of days until contract maturity;
- D = value of share dividends;
- y = number of days until dividend is paid.
- X = exercise price (equals $0.01);
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.
References
- 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
- Low Exercise Price Options Explanatory Booklet, ASX https://web.archive.org/web/20100917192520/http://asx.com.au/products/pdf/UnderstandingLEPOs.pdf