Low Exercise Price Option
Encyclopedia
In 1995 the Australian Stock Exchange
started listing of new exchange traded option
product called a Low Exercise Price Option (LEPO). A LEPO is a Europe
an style call option
with a low exercise price of $0.01 and a contract
size of 1000 share
s to be delivered on exercise.
LEPOs are traded on margin. 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
.
of LEPO.
LEPOs may be over either shares or an index
.
, less the accumulated value of any dividends, less the exercise price of $0.01.
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-Schole 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 standardized 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-Schole formula (without dividend) is
and it matches our previous formula.
Australian Stock Exchange
The Australian Securities Exchange was created by the merger of the Australian Stock Exchange and the Sydney Futures Exchange in July 2006. It is the primary stock exchange group in Australia....
started listing of new exchange traded option
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
product called a Low Exercise Price Option (LEPO). A LEPO is a Europe
Europe
Europe is, by convention, one of the world's seven continents. Comprising the westernmost peninsula of Eurasia, Europe is generally 'divided' from Asia to its east by the watershed divides of the Ural and Caucasus Mountains, the Ural River, the Caspian and Black Seas, and the waterways connecting...
an style call option
Call option
A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. 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...
with a low exercise price of $0.01 and a contract
Contract
A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...
size of 1000 share
Share (finance)
A joint stock company divides its capital into units of equal denomination. Each unit is called a share. These units are offered for sale to raise capital. This is termed as issuing shares. A person who buys share/shares of the company is called a shareholder, and by acquiring share or shares in...
s to be delivered on exercise.
LEPOs are traded on margin. The premium is close to the whole share price
Share price
A share price is the price of a single share of a number of saleable stocks of a company. Once the stock is purchased, the owner becomes a shareholder of the company that issued the share.-Behavior of share prices:...
, 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
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
.
Differences from standard options
Several important differences distinguish LEPOs from standard exchange-traded options, and these differences have important implications for the pricingPricing
Pricing is the process of determining what a company will receive in exchange for its products. Pricing factors are manufacturing cost, market place, competition, market condition, and quality of product. Pricing is also a key variable in microeconomic price allocation theory. Pricing is a...
of LEPO.
- The buyer of a LEPO does not pay the full amount of the premium upfrontUpfrontIn the North American television industry, an upfront is a meeting hosted at the start of important advertising sales periods by television network executives, attended by the press and major advertisers...
. - Both buyer and seller of LEPOs involve ongoing margin payments.
- The buyer of a LEPO does not receive dividendDividendDividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
s or obtain voting rights on 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
Index (economics)
In economics and finance, an index is a statistical measure of changes in a representative group of individual data points. These data may be derived from any number of sources, including company performance, prices, productivity, and employment. Economic indices track economic health from...
.
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 rateRisk-free interest rate
Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time....
, less the accumulated value of any dividends, less the exercise price of $0.01.
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-Schole 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 standardized 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-Schole formula (without dividend) isand it matches our previous formula.