Note on combinations of options, futures and stocks (Module 2, Part B)

1. Options can be traded on stand-alone basis. The payoffs and net gains
from such positions were analysed in the Module 2, Part A (this portion
was covered through PPT and practice sums prior to the Internal exam).
2. Select combinations of various options, futures and stocks give
outcomes which match the needs of various market participants directly.
Hence such combinations are studied as part of the overall study of the
financial derivatives.
3. This note describes features of some of the main combinations covered
in the academic literature.
4. These combinations are analysed assuming that the positions are held
till expiry of the derivative contract. This assumption helps in simplifying
the analysis. This assumption would not be necessary after we learn the
Dynamics of options ie Module 2 Part C.
5. Combination 1: Bull spread
a. Construction
i. Bull spread is constructed with reference to two prices ie
the options used in this combination have two strike prices.
ii. There are two ways in which Bull spread can be constructed
1. Buy lower strike call and sell higher strike call
a. Note that lower strike call will have higher
premium. Hence premium paid on the lower
strike call would be higher than the premium
received on the higher strike call. ie on net
basis, there would be cash outflow on account
of premiums.
2. Buy lower strike put and sell higher strike put.
a. Note that lower strike put would have lower
premium. Hence on net basis, premium would
be received.
b. Net gain on expiry
i. If market price of the underlying is equal to or higher than
the higher strike price (price level B in the chart above), max
gain occurs
ii. If market price of the underlying is equal to or less than the
lower strike (price level A in the chart above), max loss
occurs.
iii. In case of bull spread using call options
1. Max gain = Difference in the strike prices less net
premium paid
2. Max loss = Net premium paid
iv. In case of bull spread using put options
1. Max gain = net premium received
2. Max loss = Difference in strike prices less Net
premium received

c. A trader would take positions for a bull spread when the market
view is mildly bullish. This can be illustrated using bull spread
constructed using call options. If the view is firmly bullish, position
only in a long call would be entered into. In case of bull spread, in
addition to the long call position; an additional position in short
call at a higher strike price is taken. This additional position results
in trader receiving some premium. Hence on the net basis the
trader effectively reduces net premium paid. At the same time,
trader also reduces upside beyond the higher strike. Hence, such
a position is taken when the trader is mildly bullish.
d. Examples
i. Bull spread using call options
1. Construction: Let us say that there are two call
options made available to construct a bull spread viz.
95call@7 and 105call@1.2. Note that the call option
with lower strike will have higher premium.
2. Since it is a bull spread, buy lower strike call and sell
higher strike call ie buy 95call by paying premium of 7
and sell 105call by receiving premium of 1.2.
3. Net premium paid is 7 – 1.2 = 5.8
4. If the market price of the underlying on expiry is 105,
95call will give payoff of 10. 105call will not require to
pay anything. Hence the net payoff would be 10. If
the market price of the underlying on expiry is higher
than 105, say 106; then the 95call will give payoff of
11 and 105call will require making a payoff of 1. ie
the net payoff would be 11 – 1 or it would be 10. This
shows that at any price equal to or higher than 105,
the net payoff would be 10.
5. Net gain: When the net payoff is 10, the net gain
would be 10 minus the net premium paid ie 10 – 5.8 =
4.2
6. If the market price of the underlying is 95 on expiry,
95call would not give any payoff. 105call, which is
sold, would not require making any payoff if the
market price is 95 on expiry. Hence the net payoff
would be nil. Same would be the case for any price
equal to or less than 95.
7. Hence if the market price on expiry is 95 or less, the
net gain would be negative. Payoff is nil and the
premium paid is 5.8. the net gain would be -5.8.
8. Maximum gain = 4.2, maximum loss = -5.8.
9. To generalize, max gain = difference in strike less net
premium paid. Max gain happens at the higher strike
 or price higher than that. Max loss = net premium
paid. Max loss happens at lower strike or price lower
than that.
10.In between the two strikes, net gain increases with
the increase in market price of the underlying.
11.% Net gain
= Net gain / Investment made at the time of taking
the position
=Net gain / (margin% on higher strike plus net
premium paid)
Note that investment in case of a bull spread is in the
margin of the call option sold (ie the call option with
higher strike price) plus the net premium paid
If market price of underlying on expiry is 105 (given
that margin rate is 20% of strike)
net gain = 4.2 (as shown above)
Investment = 20% of 105 plus net premium paid ie
20% of 105 + 5.8 = 26.8
% net gain = 4.2 / 26.8 = 15.7%
12.Breakeven price = lower strike plus net premium paid
ie bull spread will be in profit if the market price of
the underlying at the time of expiry would be higher
than the breakeven price.
In this case, breakeven price = 95 + 5.8 = 100.8
ii. Bull spread using put options
1. Construction: Let us say that there are two put
options made available to construct a bull spread viz.
95put@0.7 and 105put@6.8. Note that the option
premium for lower strike would be lower in case of
put option. Since it is a bull spread, buy lower strike
put and sell higher strike put ie buy 95put by paying
premium of 0.7 and sell 105put by receiving premium
of 6.8.
2. Net premium received is 6.8 – 0.7 = 6.1
3. If the market price of the underlying on expiry is 105,
95put will give nil payoff. 105put will also not require
to pay anything. Hence the net payoff would be nil. If
 the market price of the underlying on expiry is higher
than 105, say 106; then the 95put will give payoff of
nil and 105put will also require making nil payoff ie
the net payoff would again be nil. This shows that at
any price equal to or higher than 105, the net payoff
would be nil.
4. Net gain: When the net payoff is nil, the net gain
would be equal to the net premium received ie 6.1.
This is the max gain possible. This happens at the
higher strike or price higher than the higher strike.
5. If the market price of the underlying is 95 on expiry,
95put would not give any payoff. 105put, which is
sold, would require trader making payoff of 10 if the
market price is 95 on expiry. Hence the net payoff
would be -10. Same would be the case for any price
equal to or less than 95.
6. Hence if the market price on expiry is 95 or less, the
net gain would be negative. Payoff is -10 and the
premium received is 6.1. The net gain would be -3.9.
7. Maximum gain = 6.1, maximum loss = -3.9
8. To generalize, max gain = net premium received. Max
gain happens at the higher strike or price higher than
that. Max loss = Difference in strike less net premium
received. Max loss happens at lower strike or price
lower than that.
9. For market prices in between the two strikes, net gain
increases with the increase in market price of the
underlying.
10.% Net gain
= Net gain / (margin% on higher strike minus net
premium received)
In this case when market price of the underlying is
105 (given that margin rate is 20% of strike)
Net gain = 6.1
Investment = 20% of 105 minus net premium
received = 21 – 6.1 = 14.9
% net gain = 6.1/14.9 = 40.9%
 11.Breakeven price = higher strike minus net premium
received. In this case, it is 98.9.(verify this using the example
above)
e. How to decide whether to use call options or put options in
constructing a bull spread? Choose the alternative that gives
higher expected % net gain. If for the bull spread with the given
set of put options, expected % net gain is higher then use the put
options. Otherwise use call options for constructing the bull
spread.
6. Bear spread:
a. Construction
i. Bear spread, similar to bull spread; is constructed with
reference to two prices ie the options used in this
combination have two strike prices.
ii. There are two ways in which Bear spread can be
constructed
1. Sell lower strike put and buy higher strike put
2. Sell lower strike call and buy higher strike call
b. Net gain on expiry
i. If market price of the underlying is equal to or higher than
the higher strike price, max loss occurs
ii. If market price of the underlying is equal to or less than the
lower strike, max gain occurs.
iii. In case of bear spread using put options
1. Max gain = Difference in the strike prices less net
premium paid
2. Max loss = Net premium paid
iv. In case of bear spread using call options
1. Max gain = net premium received
2. Max loss = Difference in strike prices less Net
premium received
c. Chart
d. Market view: A trader would take positions for a bear spread
when the market view is mildly bearish. If the view is firmly
bearish, the market position chosen would be a long put.
However, by adding a short put at lower strike, the trader receives
some premium or effectively reduces net premium paid. At the
same time, trader also reduces upside beyond the lower strike.
Hence, such a position is taken when the trader is mildly bearish.
e. Examples
i. Bear spread using put options
1. Construction: Let us say that there are two put
options made available to construct a bear spread viz.
95put@1.1 and 105put@6.2
2. Since it is a bear spread, sell lower strike put and buy
higher strike put ie sell 95put by receiving premium
of 1.1 and buy 105put by paying premium of 6.2.
3. Net premium paid is 6.2 – 1.1 = 5.1
4. If the market price of the underlying on expiry is 95,
105put will give payoff of 10. 95put will not require
to pay anything. Hence the payoff would be 10. If the
market price of the underlying on expiry is lower than
95, say 94; then the 105put will give payoff of 11 and
95put will require making a payoff of 1. ie the net
payoff would be 11 – 1 or it would be 10. This shows
that at any price equal to or lower than 95, the net
payoff would be 10.
5. Net gain: When the net payoff is 10, the net gain
would be 10 minus the net premium paid ie 10 – 5.1 =
4.9
 6. If the market price of the underlying is 105 on expiry,
95put would not require any payoff. 105put, which is
bought, would not give any payoff if the market price
is 105 on expiry. Hence the net payoff would be nil.
Same would be the case for any price equal to or
more than 105.
7. Hence if the market price on expiry is 105 or more,
the net gain would be negative. Payoff is nil and the
premium paid is 5.1. The net gain would be -5.1.
8. Maximum gain = 4.9, maximum loss = -5.1.
9. To generalize, max gain = difference in strike less net
premium paid. Max gain happens at the lower strike
or price lower than that. Max loss = net premium
paid. Max loss happens at higher strike or price
higher than that.
10.In between the two strikes, net gain decreases with
the increase in market price of the underlying.
11.% Net gain
= Net gain / (margin% on lower strike plus net
premium paid). Note that the margin % is applied to
the lower strike because in case of bear spread the
lower strike option is sold.
12.Breakeven price = higher strike minus net premium
paid ie 105 – 5.1 = 99.9
ii. Bear spread using call options
1. Construction: Let us say that there are two call
options made available to construct a bear spread viz.
95call@6.7 and 105call@1.3. Since it is a bear spread,
sell lower strike call and buy higher strike call
2. Net premium received is 6.7 – 1.3 = 5.4
3. If the market price of the underlying on expiry is 105,
95call will require payoff of 10. 105call will not pay
anything. Hence the net payoff would be -10. If the
market price of the underlying on expiry is higher
than 105, say 106; then the 95call will require payoff
of 11 and 105call will give payoff of 1 ie the net payoff
would be again -10. This shows that at any price
 equal to or higher than 105, the net payoff would be
-10.
4. When the net payoff is -10, the net gain would be
equal to the net payoff minus premium received ie
-4.6. This is the max loss possible. This happens at the
higher strike or price higher than the higher strike.
5. If the market price of the underlying is 95 on expiry,
95call would not require any payoff. 105call which is
bought would not give any payoff if the market price
is 95 on expiry. Hence the net payoff would be nil.
Same would be the case for any price equal to or less
than 95.
6. Hence if the market price on expiry is 95 or less, the
net gain would be same as the net premium received
ie 5.4 This is the maximum gain possible.
7. Maximum gain = 5.4, maximum loss = -4.6
8. To generalize, max gain = net premium received. Max
gain happens at the lower strike or price lower than
that. Max loss = Difference in strike less net premium
received. Max loss happens at higher strike or price
higher than that.
9. For market prices in between the two strikes, net gain
decreases with the increase in market price of the
underlying.
10.% Net gain
= Net gain / (margin% on lower strike minus net
premium received)
11.Breakeven price = lower strike plus net premium
received.
f. How to decide whether to use call options or put options in
constructing a bear spread? Choose the alternative that gives
higher expected % net gain.
7. Straddle:
a. Construction: One unit of long straddle is constructed using one
unit of long call and one unit of long put. One unit of short
straddle is constructed using one unit of short call and one unit of
short put. The strike prices of the call and the put are the same.
 Usually the strike price is also the same as the current market
price of the underlying ie both the options are usually at-the-
money options.
b. Net gain:
i. Net gain on long straddle = (Absolute value of difference
between the market prices at the time of taking the
position and at the time of expiry) – (total premium paid)
1. Say call option at strike 100 is purchased by paying
premium of 2 and put option at strike 100 is
purchased by paying premium of 1.5. Market price of
the underlying is 100 at the time of taking the
position ie both the options are at-the-money
options.
2. Now if the market price of the underlying at the time
of expiry is 105, the payoff on the call option is 5 and
payoff on the put option is nil. Hence the total payoff
is 5. Total premium paid is 3.5. Hence net gain is 1.5
3. If the market price of the underlying at the time of
expiry is 92 then the payoff on the put option is 8,
payoff on the call option is nil. Hence the total payoff
is 8. Total premium paid was 3.5. Hence the net gain
is 4.5
ii. Net gain on short straddle = (total premium received) -
(Absolute value of difference between the market prices at
the time of taking the position and at the time of expiry)
1. Say call option at strike 100 is sold and premium of 2
is received. Simultaneously put option at strike 100 is
sold and premium of 1.5 is received. Market price of
the underlying is 100 at the time of taking the
position ie both the options are at-the-money
options.
2. Now if the market price of the underlying at the time
of expiry is 105, the payoff on the call option is -5 and
payoff on the put option is nil. Hence the total payoff
is -5. Total premium received is 3.5. Hence net gain is
-1.5
 3. If the market price of the underlying at the time of
expiry is 92 then the payoff on the put option is -8,
payoff on the call option is nil. Hence the total payoff
is -8. Total premium paid was 3.5. Hence the net gain
is -4.5
iii. : Note that the Net gain on short straddle will be -1* net
gain on long straddle ie if net gain on long straddle is 1.5,
then net gain on short straddle is -1.5.
c. % net gain: same way as all options and combinations. % net gain
= net gain / investment. Investment in long option (for both call as
well as put) requires investing in the premium. Investment in short
option requires investing in margin less premium received.
Investing in margin is equal to margin % multiplied by the strike
price. Ie If 100strike call is sold at premium of 2 and the margin is
20% then the investment is 20% of 100 less 2 ie 18.
In case of short straddle above, investment would be 20% of 100
minus 2 ie 18 for the short call and 20% of 100 less 1.5 ie 18.5 for
the short put ie total of 36.5
d. A trader opts for long straddle when the view on the volatility is
that it would increase. There would be no view (ie neutral view)
on the market price movement of the underlying stock. If the
expectation is that market would run away either way ie up or
down; then long straddle position would get taken.
e. In case the view on the market price is neutral and the view on
the volatility is negative (ie the view is that the volatility would
reduce) then short straddle position would get taken.
f. Short straddle position is inherently risky, as markets can move
sharply overnight and huge losses may get incurred.
8. Strangle: In case the view on the volatility is mild, then straddle would
be replaced with strangle.
a. Construction: In strangle, at-the-money options are replaced with
out-of-the-money options. Premiums on at-the-money options are
higher than premiums on out-of-the-money option. Hence
strangle reduces the net premium and as well as the payoff on
expiry (vis-à-vis straddle).
b. For example, (assume that the current market price of the
underlying is 100)
 i. long straddle:
1. buy 1 unit of call with 100strike, and
2. buy 1unit of put with 100strike
ii. long strangle:
1. buy 1 unit of call with 105strike, and
2. buy 1 unit of put with 95strike
Note that at-the-money options in case of the straddle are
replaced by out-of-the money options in case of strangle.
c. Computation of net gain and % net gain is identical to that in case
of straddle.
d. Straddle is taken when view on volatility is firm. Strangle is taken
when view on volatility is mild.
i. For example, election results are expected next trading day.
There is firm view that market would sharply move up or
down depending upon the election results. In that case,
long straddle would be taken.
ii. However, If the expectation of market movement is not
firm and is somewhat tentative then long strangle would be
taken. This is so as to reduce the net premium outflow.
Long strangle would require less premium outflow than that
for long straddle. This is because out-of-the money options
in case of strangle cost less than the at-the-money options
in case of straddle.
Net gain on expiry

OTM put OTM call

ATM call
and put

Note that premium outflow is lower for strangle than that for straddle.
However, breakeven prices are higher for strangle than those for straddle.
 9. Shorting straddle as well as strangle is risky. There would be huge losses
if market moves sharply in either direction. With a view to restrict the
extent of losses, further options may be bought as illustrated below:
a. Butterfly
i. Potential loss on short straddle can be restricted by buying
out-of-the-money call and out-of-the-money put. This is
called butterfly spread
1. In other words, to construct one unit of butterfly
spread (assume market price of the underlying at
100):
a. buy 1 unit of 90put
b. sell 1 unit of 100put
c. sell 1 unit of 100call
d. sell 1 unit of 110 call
Note that butterfly spread is combination of 4
options.

butterfly spread
 short straddle

Note that losses in case of short straddle can be huge. The potential loss is
restricted in case of butterfly spread.
ii Above-mentioned butterfly spread can be considered as
combination of bull spread using put options and bear spread using call
options.
Buy 90put + sell100put is same as bull spread using put options.
Sell 100call + buy110call is same as bear spread using call options.
Hence, butterfly spread,
which is buy 90put + sell 100put + sell 100call + buy 110call
is same as
bull spread using 90 and 100 strike put options, plus
bear spread using 100 and 110 strike call options.
iii Thus a Butterfly spread is essentially a combination of bull
spread and bear spread. Butterfly spread can be constructed in 4 ways:
1. bull spread using puts and bear using calls (as shown
above, buy 90put plus sell 100put plus sell 100call plus
buy 110call)
2. bull spread using calls and bear spread using calls (buy
90call plus sell 100call plus sell 100call plus buy 110call ie
buy 90call plus sell 2 units of call at strike of 100 plus buy
110call)
3. bull spread using call options and bear spread using put
options (buy 90call plus sell 100call plus sell 100put plus
buy 110 put)
 4. bull spread using put options and bear spread using put
options (buy 90put plus sell 2 units of 100put plus buy
110put)
iv Whichever way as above gives the highest expected % net gain
would be chosen for taking the Butterfly spread positions.

b. Condor
i. Straddle to Butterfly is Strangle to Condor.
1. Butterfly as well as Condor are combinations of 4
options
2. If the two middle strike options in case of Butterfly
(eg the short options at the strike price of 100) are
replaced with two options at strikes of 95 and 105
then the combination changes from Butterfly spread
to Condor.
3. The four ways of constructing Condor are illustrated
below:
a. Buy 90put plus sell 95put plus sell 105call plus
buy 110call
b. Buy 90call plus sell 95call plus sell 105call plus
sell 110call
c. Buy 90call plus sell 95call plus sell 105put plus
buy 110put
d. Buy 90put plus sell 95put plus sell 105put plus
buy 110put
c. When volatility view is firm, Butterfly spread is preferred. When
the volatility view is not firm, Condor is preferred. In other words,
Short Straddle plus risk mitigating options lead to Butterfly spread
and short strangle plus risk mitigating options lead to Condor.
d. Calculation of net gain and % net gain is same as earlier ie like that
for a portfolio of options.

10.Synthetics
a. Synthetic long can be constructed by buying call and selling put at
the same strike.
b. It is called synthetic long because the payoffs of this combination
are similar to that of long future. It is a “synthetically” created
long contract.
c. Likewise, synthetic short instrument can be created by selling call
and buying put at the same strike.
d. Price for the synthetic = strike + call option premium minus put
option premium
e. Example:
i. Let us say one unit of call option at strike 100 is bought by
paying premium of 2 and one unit of put option at strike
100 is sold by receiving premium of 1.5.
ii. This combination is equivalent to long contract at 100.5
(100+2-1.5)
iii. we can verify this by taking various market prices of the
underlying at expiry.
1. Market price of underlying at expiry: 105
a. Long call option net gain: 5 – 2 = 3
b. Short put option net gain: 0 + 1.5 = 1.5
c. Total net gain: 4.5
d. If a long position in a future contract is taken at
100.5 and market price on expiry is 105 then
the net gain would be the same ie 4.5
2. Market price of underlying at expiry: 95
a. Long call option net gain: 0 – 2 = -2
b. Short put option net gain: -5 + 1.5 = -3.5
c. Total net gain: -5.5
d. If a long position in a future contract is taken at
100.5 and market price on expiry is 95 then the
net gain would be the same ie -5.5
3. Market price of underlying at expiry: 100
a. Long call option net gain: 0 – 2 = -2
b. Short put option net gain: 0 + 1.5 = 1.5
c. Total net gain: -0.5
d. If a long position in a future contract is taken at
100.5 and market price on expiry is 100 then
the net gain would be the same ie -0.5
 iv. If the call option is sold and put option is bought, the
combination behaves like short future at the price of 100.5.
Note the synthetic price is the same irrespective of whether
the position is synthetic long or synthetic short. The formula
for the synthetic price equal to the strike price plus the call
option premium minus the put option premium remains the
same irrespective of whether the combination is synthetic
long or synthetic short.
v. This can again be verified as shown below:
1. Market price of underlying at expiry: 105
a. Short call option net gain: -5 + 2 = -3
b. Long put option net gain: 0 - 1.5 = -1.5
c. Total net gain: -4.5
d. If a short position in a future contract is taken
at 100.5 and market price on expiry is 105 then
the net gain would be the same ie -4.5
2. Market price of underlying at expiry: 95
a. Short call option net gain: 0 + 2 = 2
b. Long put option net gain: 5 - 1.5 = 3.5
c. Total net gain: 5.5
d. If a short position in a future contract is taken
at 100.5 and market price on expiry is 95 then
the net gain would be the same ie 5.5
3. Market price of underlying at expiry: 100
a. Short call option net gain: 0 + 2 = 2
b. Long put option net gain: 0 - 1.5 = -1.5
c. Total net gain: 0.5
d. If a short position in a future contract is taken
at 100.5 and market price on expiry is 100 then
the net gain would be the same ie 0.5
11.Arbitrage using Synthetics
a. If price of a synthetic is 100.5 and the future contract is trading at
101.25 then arbitrage can be created by combination of synthetic
long and short future. In this combination, the net gain would be
0.75 (101.25 – 100.5) at the time of expiry irrespective of
whatever is the market price is at the time of expiry. Hence net
gain is with nil risk and this is therefore the arbitrage.
 b. If a synthetic price is 101.75 and the future contract is 101.25 then
arbitrage is created by combination of synthetic short and long
future.
c. Synthetic can be created from all actively traded options for an
underlying for specific expiry. These options would be across
various strike prices. Hence if synthetic for one strike (say 100) is
priced at 100.35 and synthetic for another strike (say 105) is
priced at 100.95 then combination of synthetic long using options
at strike of 100 and synthetic short using options at strike of 105
would lead to arbitrage gain of 0.65.
i. This combination is called Box spread. (Combination of
synthetic long and synthetic short)
ii. usually the combination that gives the highest % net
arbitrage gain is chosen for taking the positions.
12.Covered Call
a. Combination of long stock and short out-of-the-money call is
called covered call
b. This position is taken for a stock which is meant to be held in a
long-term portfolio but the stock has limited upside in the near
term. Hence out-of-the-money call is sold and premium is earned.
i. Let us say a stock with current market price of 100 is held in
a portfolio. The stock has no near-term upside. But it would
not be sold from the portfolio because the stock has long
term value and it cannot be predicted when the stock price
would run up to reflect its true value.
ii. In that situation, if a 30day call option on the stock at the
strike price of 110 is sold for 0.3 then this combination of
the long stock (ie stock held in the portfolio) and short call is
called covered call.
iii. In view of the limited upside potential of the stock, the
price is unlikely to cross 110 by expiry (ie30 day period).
Hence selling the 110strike call would generate net gain of
0.35.
iv. However, in case the stock price moves up and crosses 110,
the loss in the short option position is compensated by gain
in the long stock position. Hence the short call is “covered”
by the long stock.
13.Protective Put
a. If a stock with medium to long-term value is held in a portfolio and
it faces a temporary setback, then put option on the stock may be
purchased. Temporary down move in the stock price and the
resultant loss in the value of the portfolio containing this stock
would get compensated by the gain in the put option.
b. The cost for such an action is the premium to be paid for the long
put option. If the value protected is far higher than the premium
paid, this works like portfolio insurance.

14.Put-Call parity
a. It can be shown that call option premium and put option premium
need to be related to each other. They cannot remain
independent of each other for a long time.
b. The call and put premia converge based on the following formula:
i. call premium plus present value of strike =
put premium plus the current market price
c + pv of K = p + S0 , K is the strike price
ii. This can be demonstrated as shown below:
1. case I: market price on expiry(S) > K
a. payoff of long call = (S – K)
b. Value of PV(K) on expiry = K
c. Total of a, b = (S-K) + K = S
d. payoff of long put = 0
e. value of one unit of stock = S
f. Total of d, e = 0 + S = S
g. Hence both sides are equivalent in terms of
their payoff theoretically.
i. should there be a difference due to any
market inefficiency, arbitrage would
ensure that the call and put premia
converge to this relationship in
equilibrium situation.
 ii. Holding one unit of long call option plus
funds equal to the present value of strike
is equivalent to holding one unit of long
put and one unit of underlying stock
2. case II: market price on expiry(S) < K
a. payoff of long call = 0
b. Value of PV(K) on expiry = K
c. Total of a, b = 0 + K = K
d. payoff of long put = (K – S)
e. value of one unit of stock = S
f. Total of d, e = (K -S) + S = K
g. Hence both sides are equivalent in terms of
their payoff theoretically.
i. should there be a difference due to any
market inefficiency, arbitrage would
ensure that the call and put premia
converge to this relationship in
equilibrium situation.
3. Holding one unit of long call option plus funds equal
to the present value of strike is equivalent to holding
one unit of long put and one unit of underlying stock
in both the cases. Both cases cover all possible
scenarios for the market price on expiry. Hence this
would hold theoretically for all situations.