SAM FAD NOTES

Call-put parity theory

Put-call parity is a principle that defines the relationship between the price of European put
options and European call options of the same class, that is, with the same underlying asset,
strike price, and expiration date.

Put-call parity states that simultaneously holding a short European put and long European call of
the same class will deliver the same return as holding one forward contract on the same
underlying asset, with the same expiration, and a forward price equal to the option's strike price.
If the prices of the put and call options diverge so that this relationship does not hold, an
arbitrage opportunity exists, meaning that sophisticated traders can theoretically earn a risk-free
profit. Such opportunities are uncommon and short-lived in liquid markets. Put-call parity
applies only to European options, which can only be exercised on the expiration date, and not
American options, which can be exercised before. 

Put-call parity is a concept that anyone involved in options markets needs to understand. Parity is
a functional equivalence. The genius of option theory and structure is that two instruments, puts,
and calls, are complementary with respect to both pricing and valuation. Therefore, by knowing
the value of a put option you can quickly calculate the value of the complimentary call option
(with the same strike price and expiration date). There are many reasons that this is important
knowledge for traders and investors.

It can highlight profitable opportunities that present themselves when option premiums are out of
whack. Understanding put-call parity can also help you to gauge the relative value of an option
you may be considering for your portfolio.

There are two styles of options: American and European. The exercise of American options can
be at any time during their life while the exercise of European options only occurs on the options'
expiration date. Generally, put-call parity only works perfectly with European style options.

Option premiums have two components: intrinsic value and time value. Intrinsic value is the in-
the-money portion of the option. A $15 call option on silver with a premium of $1.50 when
silver is trading at $16 has $1 of intrinsic value and 50 cents of time value. Time value represents
the value of the option attributed exclusively to time. A $17 call option on silver that has a
premium of 50 cents when silver is trading at $16 has no intrinsic value and 50 cents of time
value. Therefore, in-the-money options have both intrinsic and time value while an out-of-the-
money option has only time value. Put-call parity is an extension of these concepts.

If June gold is trading at $1200 per ounce, a June $1100 call with a premium of $140 has $100 of
intrinsic value and $40 of time value. The concept of put-call parity, therefore, tells us that the
value of the June $1100 put option will be $40.

Put-call parity is an attribute of options markets that is applicable not only in commodities but in
all asset markets where options markets thrive. Spend some time and understand put-call parity
as it is a concept that will put you in a position to understand markets better than most other
market participants giving you an edge over all competition. Success in markets is often the
result of the ability to see market divergence or mispricing before others. The more you know,
the better the chances of success. 

EXPLAIN OPTIO PREMIUM OR BLACK SHOLES MODEL

1) SPOT RATE: The spot price is the current market price at which an asset is bought or sold for
immediate payment and delivery. It is differentiated from the forward price or the futures price,
which are prices at which an asset can be bought or sold for delivery in the future

2) EXERCISE PRICE: the price per share at which the owner of a traded option is entitled to buy
or sell the underlying security. The exercise price is the price at which an underlying security can
be purchased or sold when trading a call or put option, respectively. The exercise price is the
same as the strike price of an option, which is known when an investor takes a trade.

3) STANDARD DEVIATION: a quantity expressing by how much the members of a group

differ from the mean value for the group. A low standard deviation indicates that the values tend
to be close to the mean of the set, while a high standard deviation indicates that the values are
spread out over a wider range.

4) TIME PERIOD

5) CONTINUOUSLY COMPOUNDED RATE OF INTEREST: Compound interest is interest

calculated on the initial principal and also on the accumulated interest of previous periods of a
deposit or loan. The effect of compound interest depends on frequency. Continuously
compounded interest is interest that is computed on the initial principal, as well as all interest
other interest earned. The idea is that a principle will receive interest at all points in time, rather
than in a discrete way at certain points in time.

The Black Scholes model, also known as the Black-Scholes-Merton (BSM) model, is a
mathematical model for pricing an options contract. In particular, the model estimates the
variation over time of financial instruments such as stocks, and using the implied volatility of the
underlying asset derives the price of a call option. The Black-Scholes model makes certain
assumptions:

 The option is European and can only be exercised at expiration.

 No dividends are paid out during the life of the option.
 Markets are efficient (i.e., market movements cannot be predicted).
 There are no transaction costs in buying the option.
 The risk-free rate and volatility of the underlying are known and constant.
 The returns on the underlying are normally distributed.
COVERED INTEREST ARBITRAGE

Covered interest arbitrage is a strategy in which an investor uses a forward contract to hedge
against exchange rate risk. Covered interest rate arbitrage is the practice of using favorable
interest rate differentials to invest in a higher-yielding currency, and hedging the exchange risk
through a forward currency contract.

Covered interest arbitrage is only possible if the cost of hedging the exchange risk is less than the
additional return generated by investing in a higher-yielding currency - hence the word,
arbitrage. 

Returns on covered interest rate arbitrage tend to be small, especially in markets that are
competitive or with relatively low levels of information asymmetry. Part of the reason for this is
the advent of modern communications technology. Research indicates that covered interest
arbitrage was significantly higher between GBP and USD during the gold standard period due to
slower information flows.

While the percentage gains have become small, they are large when volume is taken into
consideration. A four cent gain for $100 isn't much but looks much better when millions of
dollars are involved. The drawback to this type of strategy is the complexity associated with
making simultaneous transactions across different currencies.

Such arbitrage opportunities are uncommon, since market participants will rush in to exploit an
arbitrage opportunity if one exists, and the resultant demand will quickly redress the imbalance.
An investor undertaking this strategy is making simultaneous spot and forward market
transactions, with an overall goal of obtaining risk-less profit through the combination of
currency pairs.

UNCOVERED INTEREST RATE ARBITRAGE

Uncovered interest arbitrage is a form of arbitrage that involves switching from a domestic
currency that carries a lower interest rate to a foreign currency that offers a higher rate of interest
on deposits. There is a foreign exchange risk implicit in this transaction since the investor or
speculator will need to convert the foreign currency deposit proceeds back into the domestic
currency some time in the future. The term "uncovered" in this arbitrage refers to the fact that
this foreign exchange risk is not covered through a forward or futures contract.

Uncovered interest arbitrage involves an unhedged exchange of currencies in an effort to earn

higher returns due to an interest rate differential between the two currencies. Total returns from
uncovered interest arbitrage depend considerably on currency fluctuations, since adverse
currency movements can wipe out all the gains and in fact even lead to negative returns. If the
interest rate differential obtained by investing in a foreign currency is 3%, and the foreign
currency appreciates against the domestic currency by 2% during the holding period, the total
return from this arbitrage activity is 5%. On the other hand, if the foreign currency depreciates by
4% during the holding period, the total return is -1%.