Options of futures: Pricing and the effect of an anticipated price change

A study is undertaken to examine the theoretical aspects of Black's (1976) pricing formula of commodity options and the effect on the option's premium of an anticipated future drift in the futures price. The Black formula is derived using an approach first suggested by Cox and Ross (1975). The derivation is done step by step to explain the financial intuition behind the various equations. Then, comparative statistics are used to examine the sensitivity of the formula with respect to its variables. Computer simulation analysis is employed to generate tables and diagrams, so as to illustrate the intuition behind the theoretical results and the applicability of the formulas in trading commodity options. In addition, the Cox-Ross (1975) transformation is used to show that, as long as all the information is incorporated in the prices relevant to the option's pricing formula, a drift in the commodity price will not affect the premium of a European option. Numerical examples are provided.