Module 4

Options Pricing & More

§Options Pricing (Intro)
§Put-Call Parity
§Arbitrage Opportunity
Hindustan Unilever

Date Expiry Strike Call Price Put Price Spot Time to Call + PV of Strike Put + Stock
Price Price Expiry
26-Jun-20 24-Sep-20 2,200.00 118.3 141.15 2,154.20 90.00 2,285.99 2,295.35
29-Jun-20 24-Sep-20 2,200.00 130.5 125.4 2,182.95 87.00 2,299.26 2,308.35
30-Jun-20 24-Sep-20 2,200.00 127.8 125.8 2,180.00 86.00 2,296.92 2,305.80
1-Jul-20 24-Sep-20 2,200.00 121.55 129.5 2,170.40 85.00 2,291.02 2,299.90
2-Jul-20 24-Sep-20 2,200.00 111.05 137.85 2,151.75 84.00 2,280.88 2,289.60
3-Jul-20 24-Sep-20 2,200.00 121.05 126.3 2,173.70 83.00 2,291.24 2,300.00
6-Jul-20 24-Sep-20 2,200.00 112.05 130.05 2,161.60 80.00 2,283.31 2,291.65
7-Jul-20 24-Sep-20 2,200.00 107.15 132.85 2,154.15 79.00 2,278.76 2,287.00
8-Jul-20 24-Sep-20 2,200.00 122.6 116.65 2,186.05 78.00 2,294.57 2,302.70
9-Jul-20 24-Sep-20 2,200.00 116 120.55 2,175.85 77.00 2,288.33 2,296.40
10-Jul-20 24-Sep-20 2,200.00 141.75 98.55 2,223.80 76.00 2,314.44 2,322.35
13-Jul-20 24-Sep-20 2,200.00 164.3 80.45 2,265.25 73.00 2,338.06 2,345.70
14-Jul-20 24-Sep-20 2,200.00 144.4 91.3 2,234.75 72.00 2,318.52 2,326.05
15-Jul-20 24-Sep-20 2,200.00 168.7 75.4 2,275.15 71.00 2,343.17 2,350.55
16-Jul-20 24-Sep-20 2,200.00 175.85 70.15 2,287.85 70.00 2,350.68 2,358.00
17-Jul-20 24-Sep-20 2,200.00 207.4 55.3 2,334.55 69.00 2,382.59 2,389.85
20-Jul-20 24-Sep-20 2,200.00 201.85 54.05 2,330.95 66.00 2,378.11 2,385.00
21-Jul-20 24-Sep-20 2,200.00 191.5 56.85 2,318.00 65.00 2,368.12 2,374.85
22-Jul-20 24-Sep-20 2,200.00 144.9 80.05 2,248.50 64.00 2,321.88 2,328.55
23-Jul-20 24-Sep-20 2,200.00 121.95 94.4 2,211.35 63.00 2,299.28 2,305.75
24-Jul-20 24-Sep-20 2,200.00 119.5 94.35 2,209.30 62.00 2,297.19 2,303.65
27-Jul-20 24-Sep-20 2,200.00 123.2 86.65 2,221.50 59.00 2,301.97 2,308.15
28-Jul-20 24-Sep-20 2,200.00 134.55 77.2 2,242.55 58.00 2,313.67 2,319.75
29-Jul-20 24-Sep-20 2,200.00 126.55 80.65 2,231.30 57.00 2,306.03 2,311.95
30-Jul-20 24-Sep-20 2,200.00 105.2 95.3 2,195.60 56.00 2,285.04 2,290.90
31-Jul-20 24-Sep-20 2,200.00 112 87.75 2,209.90 55.00 2,292.20 2,297.65
3-Aug-20 24-Sep-20 2,200.00 105.45 87.7 2,204.50 52.00 2,286.72 2,292.20
4-Aug-20 24-Sep-20 2,200.00 100.55 89.7 2,197.80 51.00 2,282.18 2,287.50
5-Aug-20 24-Sep-20 2,200.00 97.5 90.15 2,194.55 50.00 2,279.49 2,284.70
6-Aug-20 24-Sep-20 2,200.00 110.65 77.75 2,220.45 49.00 2,293.00 2,298.20
7-Aug-20 24-Sep-20 2,200.00 110 80.95 2,210.55 48.00 2,292.71 2,291.50
10-Aug-20 24-Sep-20 2,200.00 98.15 79.85 2,206.75 45.00 2,281.94 2,286.60
11-Aug-20 24-Sep-20 2,200.00 98.95 77.05 2,210.65 44.00 2,283.10 2,287.70
12-Aug-20 24-Sep-20 2,200.00 89.15 83.05 2,195.10 43.00 2,273.65 2,278.15
13-Aug-20 24-Sep-20 2,200.00 89.7 80.35 2,198.65 42.00 2,274.56 2,279.00
14-Aug-20 24-Sep-20 2,200.00 75.75 91.35 2,173.90 41.00 2,260.97 2,265.25
17-Aug-20 24-Sep-20 2,200.00 83.4 77.65 2,196.05 38.00 2,269.70 2,273.70
18-Aug-20 24-Sep-20 2,200.00 88 65.4 2,214.35 37.00 2,274.66 2,279.75
19-Aug-20 24-Sep-20 2,200.00 76.85 69.1 2,193.60 36.00 2,263.87 2,262.70
20-Aug-20 24-Sep-20 2,200.00 68.55 75.6 2,185.70 35.00 2,255.93 2,261.30
21-Aug-20 24-Sep-20 2,200.00 74.6 61.2 2,202.05 34.00 2,262.34 2,263.25
24-Aug-20 24-Sep-20 2,200.00 65.95 58 2,194.40 31.00 2,254.77 2,252.40
25-Aug-20 24-Sep-20 2,200.00 54.55 65.15 2,179.10 30.00 2,243.73 2,244.25
26-Aug-20 24-Sep-20 2,200.00 54.75 63.85 2,182.80 29.00 2,244.29 2,246.65
27-Aug-20 24-Sep-20 2,200.00 51.55 68 2,171.25 28.00 2,241.45 2,239.25
28-Aug-20 24-Sep-20 2,200.00 39.5 78.55 2,151.95 27.00 2,229.76 2,230.50
31-Aug-20 24-Sep-20 2,200.00 32.45 103.85 2,117.35 24.00 2,223.79 2,221.20
1-Sep-20 24-Sep-20 2,200.00 43.2 66.9 2,161.65 23.00 2,234.90 2,228.55
2-Sep-20 24-Sep-20 2,200.00 36.6 82.55 2,141.65 22.00 2,228.66 2,224.20
3-Sep-20 24-Sep-20 2,200.00 33.35 81.95 2,139.15 21.00 2,225.77 2,221.10
4-Sep-20 24-Sep-20 2,200.00 27.3 95.9 2,124.65 20.00 2,220.08 2,220.55
7-Sep-20 24-Sep-20 2,200.00 34.45 67.35 2,162.60 17.00 2,228.31 2,229.95
8-Sep-20 24-Sep-20 2,200.00 26.25 79 2,142.25 16.00 2,220.47 2,221.25
9-Sep-20 24-Sep-20 2,200.00 22.95 82.85 2,132.25 15.00 2,217.53 2,215.10
10-Sep-20 24-Sep-20 2,200.00 22.95 84.5 2,133.90 14.00 2,217.89 2,218.40
11-Sep-20 24-Sep-20 2,200.00 28 61.25 2,159.25 13.00 2,223.30 2,220.50
14-Sep-20 24-Sep-20 2,200.00 17.1 88.8 2,123.50 10.00 2,213.49 2,212.30
15-Sep-20 24-Sep-20 2,200.00 14.45 87.5 2,124.45 9.00 2,211.20 2,211.95
16-Sep-20 24-Sep-20 2,200.00 15.5 69 2,143.50 8.00 2,212.61 2,212.50
17-Sep-20 24-Sep-20 2,200.00 10.7 79 2,128.20 7.00 2,208.17 2,207.20
18-Sep-20 24-Sep-20 2,200.00 4.65 103.05 2,098.70 6.00 2,202.48 2,201.75
21-Sep-20 24-Sep-20 2,200.00 1.95 160.75 2,037.80 3.00 2,200.87 2,198.55
22-Sep-20 24-Sep-20 2,200.00 0.85 172.7 2,026.80 2.00 2,200.13 2,199.50
23-Sep-20 24-Sep-20 2,200.00 0.5 145 2,052.55 1.00 2,200.14 2,197.55
24-Sep-20 24-Sep-20 2,200.00 0.1 141.6 2,060.90 0.00 2,200.10 2,202.50
 Risk Free Rate 6% p.a.
Difference
Time to expiry
-9.36 Call Price + PV (Strike) = Put Price + Stock
-9.09
-8.88
-8.88
-8.72
-8.76
-8.34
-8.24
-8.13
-8.07
-7.91
-7.64
-7.53
-7.38
-7.32
-7.26
-6.89
-6.73
-6.67
-6.47
-6.46
-6.18
-6.08
-5.92
-5.86
-5.45
-5.48
-5.32
-5.21
-5.20
1.21
-4.66
-4.60
-4.50
-4.44
-4.28
-4.00
-5.09
1.17
-5.37
-0.91
2.37
-0.52
-2.36
2.20
-0.74
2.59
6.35
4.46
4.67
-0.47
-1.64
-0.78
2.43
-0.51
2.80
1.19
-0.75
0.11
0.97
0.73
2.32
0.63
2.59
-2.40
 Date Expiry Strike Price Call Price Put Price Spot Price Time to Call + PV of
Expiry Strike
26-Jun-20 24-Sep-20 2,200.00 118.3 141.15 2,154.20 90.00 2,285.99

Arbitrage Buy Cheap Buy LHS 2,285.99

Sell Expensive Sell RHS 2,295.35
9.36

Leg Action Pay Receive Net Cashflow

Call Buy 118.30 -118.30
LHS
PV(Strike) Buy 2,167.69 -2,167.69
Stock Sell 2,154.20 2,154.20
RHS
Put Sell 141.15 141.15
Total Cashflow 9.36
 Put + Difference
Stock
2,295.35 -9.36
 Stock price is Rs 100
Put price is Rs 15
Strike price is Rs 100
Risk free rate is 6% p.a.
Time to expiry 3 months
Q1.1 What should be price of Call price as per Put-Call Parity?

Ans Put Call Parity

Stock + Put = PV(Strike) + Call

Call Price = Stock Price + Put Price - PV(Strike)

= 16.49

Q1.2 What if the actual Call price is

a) Rs 18
b) Rs 15
What can you do? Is there an arbitrage opportunity? If yes, how will you take advantage of the arbitage? Show Calc

Ans
a) Actual Call Price is Rs 18
Since actual Call price is higher than expected price, an arbitrage opportunity exists (theoretically)
To take advantage of the arbitrage, Buy Cheap & Sell Expensive

There are two legs to replicate the same transaction

Stock + Put = PV(Strike) + Call

Buy the cheap leg & Sell the expensive leg

Buy: Stock + Put
Sell: PV(Strike) + Call

Transaction Pay Receive Net Cashflow

Buy Stock 100 -100
Buy Put 15 -15
Sell Call 18 18
Sell PV(Strike) i.e. borrow PV(Strike) 98.51 98.51
Total Cashflow (A) 1.51

Now three possibilities exist on expiry

i) Stock price < Strike Price
ii) Stock price > Strike Price
iii) Stock price = Strike Price

Let's evaluate each possibility

i) Stock price < Strike Price
Let's assume Stock price on expiry is Rs 90
Strike Price is Rs 100
 In this case

Existing Position Square off Position Payoff

Long Stock Sell stock at Rs 90 90
Long Put Put gets exercised 10
Short Call Call expires worthless 0
Borrowed PV(Strike) Pay Strike price to Bank -100
Total Cashflow (B) 0

Final Cashflow position for You = Cashflow (A) + Cashflow (B)

= 1.51
i.e. you get to keep Rs 1.51

ii) Stock price > Strike Price

Let's assume Stock price on expiry is Rs 115
Strike Price is Rs 100

In this case

Existing Position Square off Position Payoff

Long Stock Sell stock at Rs 115 115
Long Put Put expires worthless 0
Short Call Call gets exercised -15
Borrowed PV(Strike) Pay Strike price to Bank -100
Total Cashflow (B) 0

Final Cashflow position for You = Cashflow (A) + Cashflow (B)

= 1.51
i.e. you get to keep Rs 1.51

iii) Stock price = Strike Price

Stock price on expiry is Rs 100
Strike Price is Rs 100

In this case

Existing Position Square off Position Payoff

Long Stock Sell stock at Rs 100 100
Put expires worthless/
Long Put gets exercised 0
Call expires worthless/
Short Call gets exercised 0
Borrowed PV(Strike) Pay Strike price to Bank -100
Total Cashflow (B) 0
Final Cashflow position for You = Cashflow (A) + Cashflow (B)
= 1.51
i.e. you get to keep Rs 1.51
f the arbitage? Show Calculations