PUT-CALL PARITY FOR EXOTIC EUROPEAN OPTIONS

GIUSEPPE CASTELLACCI
ABSTRACT. I propose a simple generalization of put-call parity that holds for a large class
of exotic European options. The result rests on a reasonable generalization of the concepts
of put and call. The proof is based on the fundamental theorem of arbitrage pricing and
elementary properties of real numbers. I also propose a generalization of the notion of
intrinsic value and volatility smile. Here I leverage on the relationship between put-call
parity and the smile/smirk in the vanilla case.
CONTENTS
1. Introduction 1
1.1. Reminder of Basic Put-Call Parity 3
2. Generalization to Exotic European Options 3
2.1. The Generalized Put-Call Parity 4
3. Put Call Parity and Volatility Smiles 7
3.1. Reminder of Vanilla Smiles 7
3.2. Generalizing European Smiles 8
Appendix A. Stochastic Assumptions 12
Appendix B. The Intrinsic Value of European Vanilla Options 13
References 15
1. INTRODUCTION
Generally, put-call parity refers to an equality relating vanilla puts and calls, however it
can be proven for any exotic European option for which a reasonable notion of put and call
is available.
Date: This Draft: June 28, 2009; First Draft: March 15, 2007.
Key words and phrases. No-Arbitrage Equalities, Put-Call Parity, Arbitrage Pricing, European Options, Ex-
otic Options.
Typeset in LAT
E
X2.
This paper shared its original title with [BE93]. There is minimal overlap between these two papers as
discussed below.
1
1. Introduction PUT-CALL PARITY FOR EUROPEAN EXOTICS
Accordingly, my rst goal to generalize the notion of European put and call. Once
a suitable abstraction of the payoff of a call and of a put is isolated, put-call parity will
follow from the rst Fundamental Theorem of Arbitrage Pricing and elementary properties
of (the lattice of) real numbers. A number of incarnations of the classical put-call parity
for vanilla European options and corresponding proofs can be found, each corresponding
to an exotic payoff. These include Asian options [Lev92], basket options, spread options
[Pea95], and combinations thereof such as Asian basket spread options [CS03]. These
payoffs are quite common for commodities, currency, and to a lesser extent equity and
interest rate securities. A well know instance in interest rates markets is the cap-oor parity
(cf., e.g., [BM06, Chap. 1]). In most such cases, put-call parity has obvious applications
not only in hedging and arbitrage, but also in the modeling itself (closed formulas, often
approximations, must be only derived in the case of a call or a put).
The paper that comes closest in spirit to the present one is probably [BE93].
1
I would
like to stress that [BE93] focuses on options on the minimum and maximum of two asset
prices and other options that can be hence constructed, such as quantity-adjusting options.
The parity relations and even the notion of put and call are different. In particular, the no-
tion of put and call I propose insists on preserving the shape of [(f(X
1
, . . . , X
n
) K)]
+
,
where f is a suitable Borelian function of market factors X
1
, . . . , X
n
and K is the strike.
On the other hand, in [BE93] the parities involve max(X, Y ), min(X, Y ) and possibly
sums of binomials that comprise them, where X and Y can be either market factors or
simple shifts thereof by a strike. Therefore, except for the most basic cases, these two
papers have different goals and viewpoints and have minimal overlapping.
Despite the ourishing of such results, there does not seem to be a formulation (and
rigorous proof) of put-call parity that holds in general. The reason is perhaps that most
such proofs rely on the idiosyncratic nature of the option at hand and do not attempt to
abstract its payoff. Some make use of replicating arguments. In contrast, I attempt to
formalize the notions of call and put abstracting from the specic payoff. The proof I offer
is solely based on arbitrage pricing theory making no appeal to portfolio replication (such
as [Hul00, Section 7.4]), which would have to resort to the specic structure of the option.
Hence the price of such generalization is the remote economic nature of the argument.
I present the results in two sections. In Section 2 I provide the proof of the main result
and attend it with a potpourri of examples and remarks. Although the proofs I present do
not use replicating arguments, they do not make any specic modeling assumptions other
than the generalities needed for the fundamental theorem of arbitrage pricing to apply. In
particular, we do not assume any specic dynamics for the underlying asset prices.
1
The present paper was originally identically titled. I am indebted to Peter Carr for pointing this out.
2 Giuseppe Castellacci
PUT-CALL PARITY FOR EUROPEAN EXOTICS 2. Generalization to Exotic European Options
I summarize the necessary underlying assumptions of an arbitrage-free market model
in Appendix A. Here, sufce it to say that the arbitrage price of an attainable European
security can be written as
V (t) = V (t; X, T) = H(t)E
(H)
t
_
v(X
1
(T), . . . , X
n
(T))
H(T)
_
, (1.1)
where v is the payoff at T T , E
(H)
t
[] denotes the conditional expectation up to time t
with respect to a suitable martingale measure, and H is the num eraire.
In Section 3 I attempt to generalize the notion of smile/smirk that is commonly modeled
in vanilla options. Here I focus on the one-dimensional notion (that is, volatility depends
only on strike or moneyness, and does not have a term structure, let alone depends on tenor
as in the case of the swaption volatility cube). This generalization captures the salient
feature of vanilla smiles, that is systematic mispricing deep off the money. The basic
idea is that for very large (resp., near zero) strikes the market prices calls (resp., puts)
more expensively than their intrinsic values. Correspondingly, we generalize the notion of
intrinsic value whence our generalization of smile depends.
1.1. Reminder of Basic Put-Call Parity. Denoting with V
CALL
(t) the arbitrage price of a
vanilla European call and with V
PUT
(t) the corresponding put price, put call parity main-
tains that
V
CALL
(t) V
PUT
(t) = X(t) KP(t, T) (1.2)
where X denotes the underlying price process, K the strike, and P(t, T) the price of a
T-maturity zero coupon bond at time t. If V
AM-CALL
(t) and V
AM-PUT
(t) denote the arbitrage
prices of the corresponding call and put, respectively, then one has the following inequality
X(t) K V
AM-CALL
(t) V
AM-PUT
(t) X(t) KP(t, T). (1.3)
European put-call parity and its American (weaker) generalization hold under the assump-
tion of no arbitrage, regardless of the model for the underlying asset dynamics. As hinted,
they are usually proven by portfolio replicating strategies (cf., e.g., [MR05, Proposition
1.8.1])
2. GENERALIZATION TO EXOTIC EUROPEAN OPTIONS
The generalization of put-call parity I am about to propose inherently rests on a corre-
sponding generalization of the vanilla notions of put and call, which I proceed to lay out.
Denition 2.1 (European f-Call and f-Put). Consider a real (Borel-measurable) integrable
function of n variables f = f(x
1
, . . . , x
n
). A European call corresponding to f with
Giuseppe Castellacci 3
2. Generalization to Exotic European Options PUT-CALL PARITY FOR EUROPEAN EXOTICS
expiration T T , or, briey, an f-call, is the derivative having payoff at T
v
CALL
(X
T
) = max [f(X
1
(T), . . . , X
n
(T)), 0] = [f(X
1
(T), . . . , X
n
(T))]
+
. (2.1)
A European put corresponding to f with expiration T T , or, briey, an f-put, is the
derivative having payoff at T
v
PUT
(X
T
) = max [f(X
1
(T), . . . , X
n
(T)), 0] = [f(X
1
(T), . . . , X
n
(T))]
+
. (2.2)
Whenever it is not necessary to distinguish between an f-call and f-put, I will use the
terminology f-option.
Example 2.1. Apart from the trivial vanilla case (f(x) = x K where x is the asset
price and K is the strike), one can immediately recast in this formalism familiar European
payoffs. For example, spread call options correspond to
f(x
1
, x
2
) = x
1
x
2
K (2.3)
and basket options correspond to
f(x
1
, . . . , x
n
) =
n

i=1
w
i
x
i
K, (2.4)
where K is the strike and w
i
are weights assumed positive (but not necessarily summing
to unity).
Remark 2.1. In all these cases, we assumed the factors were the asset prices themselves,
so that one substitutes x
i
= X
i
(T) to obtain the options payoff. We could have assumed
returns as factors (corresponding to x
i
= e
Xi(T)
) or some other transformation of asset
prices.
Remark 2.2. One can easily extend the above denition to include European options with
resets, such as Asian and Asian-basket options. This would only clutter the notation with
no additional theoretical complexity.
2.1. The Generalized Put-Call Parity. Henceforth, unless the dependence on the den-
ing f must be emphasized to avoid ambiguity, I will denote with V
CALL
(t) the arbitrage
price of an f-call and with V
PUT
(t) the corresponding f-put price.
Theorem 2.1. Under the previous assumptions, the following relation holds between f-
calls and f-puts
V
CALL
(t) V
PUT
(t) = H(t)E
(H)
t
_
f(X
1
(T), . . . , X
n
(T))
H(T)
_
. (2.5)
4 Giuseppe Castellacci
PUT-CALL PARITY FOR EUROPEAN EXOTICS 2. Generalization to Exotic European Options
Proof. The claim results from the following basic ordinal property or real numbers: for
any x R
[x]
+
[x]
+
= x. (2.6)
To wit, since at expiration one has
v
CALL
(X1(T),...,Xn(T))v
PUT
(X1(T),...,Xn(T))
H(T)
=
=
[f(X1(T),...,Xn(T))]+[f(X1(T),...,Xn(T))]+
H(T)
= (2.7)
=
f(X1(T),...,Xn(T)))
H(T)
the thesis (2.5) follows by taking expectations with respect to the H-martingale measure

Remark 2.3. If the i-th asset pays an income (dividend or convenience yield) at the de-
terministic rate q
i
= q
i
(t) a nonnegative function dened over T , then the above put-call
parity can be easily generalized in the case in which the X
i
are asset prices by considering
the income adjusted asset prices

X
i
(t) := e
Qi(t)
X
i
(t),
where Q
i
(t) =
_
t
0
q
i
(u)du. Then the put-call parity can be written as
V
CALL
(t) V
PUT
(t) = H(t)E
(H)
t
_
f(

X
1
(T), . . . ,

X
n
(T))
H(T)
_
. (2.8)
Remark 2.4. In many cases, the function f can be written as
f(x
i
, x
2
, . . . , x
n
) = g(x
1
, x
2
, . . . , x
n
) K (2.9)
In this case we can write put-call parity as
V
CALL
(t) V
PUT
(t) = H(t)E
(H)
t
_
g(X
1
(T), . . . , X
n
(T))
H(T)
_
KE
(H)
t
_
H(t)
H(T)
_
. (2.10)
Further, since E
(H)
t
_
H(t)
H(T)
_
represents the arbitrage price of one unit of currency delivered
at time T, we can write
E
(H)
t
_
H(t)
H(T)
_
= P(t, T), (2.11)
where P(t, T) denotes the price of the T-maturity zero coupon bond (ZCB) at time t.
Example 2.2. Consider spread options corresponding to f(x
1
, x
2
) = x
1
x
2
K. Assume
that the underlying assets do not provide any income. Then the spread option incarnation
of put-call parity claims that
V
CALL
(t) V
PUT
(t) =
= H(t)
_
E
(H)
t
[X
1
(T)/H(T)] E
(H)
t
[X
2
(T)/H(T)]
_
KP(t, T).
(2.12)
Giuseppe Castellacci 5
2. Generalization to Exotic European Options PUT-CALL PARITY FOR EUROPEAN EXOTICS
Recall that H-discounted asset prices are martingales with respect to the H-martingale
measure, so that E
(H)
t
[X
i
(T)/H(T)] = X
i
(t)/H(t). Hence we can rewrite the above
equality as
V
CALL
(t) V
PUT
(t) = X
1
(t) X
2
(t) KP(t, T). (2.13)
If the i-th asset pays income at the rate q
i
= q
i
(u) then, thanks to Remark 2.3 we can write
V
CALL
(t) V
PUT
(t) = e
Q1(t)Q1(T)
X
1
(t) e
Q2(t)Q2(T)
X
2
(t) KP(t, T). (2.14)
Notice that this covers the special case of the X
i
representing futures prices, which can
be identied with securities paying an income rate equal to the risk-less rate, provided the
latter can be assumed deterministic. In this case Q
i
(t) Q
i
(T) =
_
T
t
r(u)du.
Example 2.3. Consider basket options corresponding to f(x
1
, x
2
, . . . , x
n
) =

n
i=1
w
i
x
i

K. First that the underlying assets do not provide any income. Then the basket option in-
carnation of put-call parity claims that
V
CALL
(t) V
PUT
(t) =
= H(t)
n

i=1
w
i
E
(H)
t
[X
i
(T)/H(T)] KP(t, T).
(2.15)
Using once again the martingale nature of H-discounted asset prices, so that E
(H)
t
[X
i
(T)/H(T)] =
X
i
(t)/H(t), we can rewrite the above equality as
V
CALL
(t) V
PUT
(t) =
n

i=1
w
i
X
i
(t) KP(t, T). (2.16)
As in the case of spread options, this put-call parity can be extended to the case of assets
paying income at the deterministic rate q
i
= q
i
(u) (i = 1, . . . , n). Thanks to Remark 2.3
we can write
V
CALL
(t) V
PUT
(t) =
n

i=1
w
i
e
Qi(t)Qi(T)
X
i
(t) KP(t, T), (2.17)
which also cover the case of futures prices provided the short rate can be assumed deter-
ministic.
Remark 2.5. One can dene a European derivative F(T) = f(X
1
(T), . . . , X
n
(T)) and
assume it is attainable. Then the previous theorem establishes that
V
CALL
(t) V
PUT
(t) = F(t), (2.18)
where F(t) = F(t; X, T) the denotes the arbitrage price of the security F(T). in the case
of vanilla calls and puts, this security is a portfolio consisting of a long position in one unit
of the underlying together with a short position in K units of ZCBs. In the case of basket
options the security can be regarded as a portfolio consisting of n long positions each with
w
i
units of the i-th security along with K short ZCBs. More generally, whenever one
6 Giuseppe Castellacci
PUT-CALL PARITY FOR EUROPEAN EXOTICS 3. Put Call Parity and Volatility Smiles
can write f(x
i
, x
2
, . . . , x
n
) = g(x
1
, x
2
, . . . , x
n
) K, the security will comprise K short
ZCBs.
3. PUT CALL PARITY AND VOLATILITY SMILES
Broadly speaking, the notion of volatility smile or smirk refers to the non-constancy of
volatility implied by the market prices of options with different strikes and all other pa-
rameters equal. When one lets expiry vary as well, a volatility surface is observed. Gen-
erally one does not consider higher-dimensional volatility manifolds, which would result
from the parametrization of implied volatility as a function of further parameters.
2
In this
section I assume that factors are asset prices and to stress this I will use the notation S or
S, instead of X of Xfor the factor process.
3.1. Reminder of Vanilla Smiles. Let us rst consider vanilla European options. Because
it is model-independent, put call parity must hold for market prices as well to rule out
arbitrage:
V
MKT-CALL
(t; K) V
MKT-PUT
(t; K) = S(t) KP(t, T), (3.1)
where V
MKT-CALL
(t; K) denotes the market price
3
of a European call of strike K at time t,
V
MKT-PUT
(t; K) the corresponding put price, and S the underlying price process.
A common observation (cf., e.g., [Hul06]) is that put-call parity implies that the error a
model makes in pricing a call is the same as the corresponding puts error:
V
MKT-CALL
(t; K) V
CALL
(t; K) = V
MKT-PUT
(t; K) V
PUT
(t; K), (3.2)
where V
CALL
and V
PUT
denote the arbitrage price of a call and put , respectively, calculated
via a specic model. This also immediately entails that the volatility implied via calls is
the same as the one implied via otherwise identical puts, for such implied volatility makes
both sides of the above equation zero.
A typical smile or smirk entails that deep OTM vanilla options have higher implied
volatility than the otherwise identical ATM, the implication occurring via Black-Scholes.
To make this more precise, let us denote with V
BS-CALL
(t; K, ) (resp. V
BS-PUT
(t; K, )) the
Black-Scholes price at time t of a call (resp. a put) with strike K and underlying volatility
, and let
IV
(t; K) stand for the volatility implied (via Black-Scholes) from the European
2
One notable exception is the case of swaptions in which considering different tenors, expiries, and strikes
leads to volatility three-folds. However, often strikes are kept constant at the money, so that only volatility
surfaces are consideredalbeit of a different parametric nature than equity or commodity volatility surfaces.
3
We ignore the issue of determining a representative market price from bid, ask, and mid trade prices or
quotes. We also assume substantial liquidity of the corresponding options.
Giuseppe Castellacci 7
3. Put Call Parity and Volatility Smiles PUT-CALL PARITY FOR EUROPEAN EXOTICS
vanilla options market price at time t with strike K. Then a typical smile is such that, for
K S(t) (deep OTM put),
V
MKT-PUT
(t; K) > V
BS-PUT
(t; K,
IV
(t; S(t)) 0, (3.3)
where the last approximation simply follows from the fact that the put is virtually worthless
in the Black-Scholes framework. In turn, put-call parity implies that
V
MKT-CALL
(t; K) = V
MKT-PUT
(t : K) +S(t) KP(t, T) >
> V
BS-CALL
(t; K,
IV
(t; S(t)).
For V
BS-CALL
(t; K,
IV
(t; S(t)) S(t) KP(t, T), the call being deep ITM. We remark
that the Black-Scholes values of the call and put are (approximately) their intrinsic value.
4
Also notice that this argument is reversible (i.e., if V
MKT-CALL
(t; K) > V
BS-CALL
(t; K,
IV
(t; S(t))
then V
MKT-PUT
(t; K) > V
BS-PUT
(t; K,
IV
(t; S(t))), which makes it an equivalence. Finally,
notice that the same equivalence holds for deep OTM calls and their corresponding deep
ITM puts. In sum, we have shown that for deep off-the-money vanilla Europeans, i.e.,
|K S(t)| 0,
V
MKT-PUT
(t; K) > V
BS-PUT
(t; K,
IV
(t; S(t))
V
MKT-CALL
(t; K) > V
BS-CALL
(t; K,
IV
(t; S(t)).
(3.4)
Therefore, put-call parity bears on the curvature of the volatility smile, for deep off the
money puts are appreciably worthier than intrinsic value if and only if so are the corre-
sponding calls.
3.2. Generalizing European Smiles. I proceed to abstract the above recalled notions to
the setting of generalized (exotic) European calls and puts.
I rst generalize the notion of European intrinsic value stressing the difference between
the European and American version of such notions. The latter is well known, whereas
the former is often dened by practitioners as the result of freezing the randomness in the
price of an option or, equivalently in the Black-Scholes or similar model, the limit of such
price as the volatility tends to zero. I review these concepts in the vanilla case in Appendix
B.
4
Recall that for a European option, the intrinsic value of a call can be dened as the right limit of the option
value as the volatility 0
+
. Intuitively, this means freezing the randomness in the option underlying (it is
not necessary to freeze interest rate risk). This assumes that the underlying returns follow a one-dimensional
diffusion. However, the freezing idea yields the same intrinsic value even for more general diffusions or
discontinuous dynamics. Below we generalize this denition.
8 Giuseppe Castellacci
PUT-CALL PARITY FOR EUROPEAN EXOTICS 3. Put Call Parity and Volatility Smiles
In the general European exotic setting, if one freezes the i-th asset dynamics at time
t, the value of such asset can be assumed to equal its T-forward value for the purpose of
valuing the option. Indeed, the arbitrage price of the i-th asset should be
S
i
(t) = H(t)E
(H)
t
_
S
i
(T)
H(T)
_
. (3.5)
But since S
i
(T) is not random any more in this frozen world, it can be taken out of the
expectation, so that
S
i
(t)
P(t, T)
=
S
i
(t)
E
(H)
t
[H(t)/H(T)]
= S
i
(T). (3.6)
The left-hand side is none other than the T-forward price of the i-th asset,
5
denoted with
F
i
(t, T) :=
S
i
(t)
P(t, T)
, (3.7)
so that we can write
6
S
i
(T) = F
i
(t, T). (3.8)
This suggests to substitute forward prices in the payoffs of European options and motivate
the following denition
Denition 3.1 (Generalized European Intrinsic Value). The intrinsic value of a European
f-call and f-put with maturity T is dened as
IV (S(t); f, ) := P(t, T) [f(F
1
(t, T), . . . , F
n
(t, T))]
+
, (3.9)
where
=
_
_
_
1 if the option is an f-call
1 if the option is an f-put.
(3.10)
Remark 3.1. Notice that in this general setting too, the European notion of intrinsic value
can be regarded as a discounting correction to the more widespread notion of American
intrinsic value, which could be simply dened as
[f(S
1
(t), . . . , S
n
(t))]
+
. (3.11)
5
Cf., e.g., [MR05, Lemma 9.6.1].
6
This result is also intuitive. In a world in which the risk factors that drive the dynamics of asset prices (but not
necessarily of interest rates) are frozen, the future value of such assets must coincide with their current forward
price, which is the price that makes the corresponding forward contract currently worthless. Yet another way to
consider this valuation is to consider the replicating strategy for the option. Here the i-th asset can be regarded as
a deposit of S
i
(t) with maturity T.
Giuseppe Castellacci 9
3. Put Call Parity and Volatility Smiles PUT-CALL PARITY FOR EUROPEAN EXOTICS
Remark 3.2. In the case in which one can write f(x
1
, . . . , x
n
) = g(x
1
, . . . , x
n
) K and
g is homogenous of degree one
IV (S(t); f, ) = [(g(S
1
(t), . . . , S
n
(t)) KP(t, T))]
+
. (3.12)
Also, if one further assumes that g is linear, then
IV (S(t); f, ) = H(t)E
(H)
t
_
f(S
1
(T), . . . , S
n
(T))
H(T)
_
. (3.13)
Notice the the right-hand side is the same as in the generalized put-call parity. Notice also
that comprises vanilla options as well as the exotic examples considered above.
Denition 3.2 (Generalized Moneyness). An f-option is said to be at-the-money (ATM)
at time t if
IV (S(t); f, ) = 0. (3.14)
An f-option is said to be in-the-money (ITM) at time t if
IV (S(t); f, ) > 0. (3.15)
Finally, an f-option is said to be out-of-the-money (OTM) at time t
f(F
1
(t, T), . . . , F
n
(t, T)) < 0. (3.16)
Deep moneyness is dened similarly.
7
Remark 3.3. Note that deep moneyness does not depend on the version of intrinsic value
i.e., the one we explicitly dened vs. its American counterpart, which is not discounted.
The concept of smile or smirk for vanilla options applies to a given family of calls
and puts. In the simplest case, this family can be parameterized with the strike. One can
consider higher-dimensional parameter spaces, such as those dened by strike and expiries,
or tenor, expiry and strike in the case of swaptions. In general, it seems that a smile should
be a property of a parametric family of options which is especially relevant deeply off-the
money.
Denition 3.3 (Smile Structure). A smile structure consists of a triplet = (A, {

}, K
0
)
dened as follows:
(i) a parametric family of integrable functions A := {f

}
K
where the parameter
space K R
k
;
(ii) a pair of positive bounded function

: S K R
+
, {1, 1}, and S R
n
+
;
(iii) a bounded domain K
0
K.
7
E.g., a deep ITM f-option is one for which IV (f; ) 0.
10 Giuseppe Castellacci
PUT-CALL PARITY FOR EUROPEAN EXOTICS 3. Put Call Parity and Volatility Smiles
The family A denes a family of European f

-options, denoted with B(A). We require

that

(s, ) > IV (s; f

, ) (3.17)
for every (s, ) S (K K
0
).
Remark 3.4. In this denition the parameter space K generalizes the notion of the set
of strikes and other parameters that dene families of vanilla options. The domain S,
generally unbounded, represents the state space of the market variables, possibly the entire
positive orthant R
n
+
. The bounded domain K
0
represents the set of options near the money.
In the vanilla case parameterized by strikes only this could be an interval of the form
(S(t) , S(t) + ), for some R
+
. The functions

quantify by how much deep

off-the-money options are worthier than intrinsic value, which is the essential feature of
vanilla smiles I am attempting to generalize.
For options in a family B B(A) we dene V
MKT
(; ) to be the market price of the
f

-option with payoff at T

v(; ) = [f

(S
1
(T), . . . , S
n
(T))]
+
. (3.18)
Denition 3.4 (Generalized Smile). A family of option B is said to satisfy a generalized
smile property if there is a smile structure such that B B(A) and that for every option
in the family
V
MKT
(; )

(s, ). (3.19)
Remark 3.5. The denition of generalized smiles attempts to extend the salient feature
of European vanilla smiles by which deep off-the-money options are worthier than their
intrinsic value. Vanilla intrinsic values for in the money options happen to coincide with
the right-hand side of put-call parity. Under this assumption, or more precisely, assuming

(s, ) > H(t)E

(H)
t
_
f(S
1
(T), . . . , S
n
(T))
H(T)
_
, (3.20)
one can expect a family of European options with the generalized smile property to be
endowed with an analogous rigidity as vanilla options. Indeed, since
V
MKT
(; 1) V
MKT
(; 1) = H(t)E
(H)
t
_
f(S
1
(T), . . . , S
n
(T))
H(T)
_
, (3.21)
the smile feature for a deep off-the-money call implies the same for the corresponding put
and viceversa.
Giuseppe Castellacci 11
A. Stochastic Assumptions PUT-CALL PARITY FOR EUROPEAN EXOTICS
APPENDIX A. STOCHASTIC ASSUMPTIONS
I assume the standard stochastic package, and in particular, that our stochastic base (, F

, P)
satises the usual conditions (cf., e.g., [Pro05, Chap. I, Sec 1]), so that the ltration F

is
increasing and right continuous.
Our market model is dened by an n-dimensional factor process {X(t)}
tT
,
8
where T
represents the time horizon. Generally, T = [0, T

], where T

. In other words, the

process X does not necessarily represent the prices of n traded assets. On the other hand,
I rule out arbitrage, so that, by the rst fundamental theorem of arbitrage pricing, the price
processes of all attainable
9
securities relative to a given num eraire H are martingales.
More formally, this means that there exists an n-dimensional securities price process
{S(t)}
tT
, and a positive price process {H(t)}
tT
such that S/H and all derivatives of
the S
i
are martingales with respect to a measure that is equivalent to P. In general, we
assume there exists a Borel-measurable mapping : R
n
R
n
such that S(t) = (X(t))
for all t T . However, I will usually assume the factors are prices of traded assets so
that this mapping is the identity. A European security can be dened as an F
T
measurable
random variable. We will only consider European securities corresponding to payoffs at
time T, i.e., representable as functions v = v(X
1
(T), . . . , X
n
(T)). Their arbitrage price
can be written as
V (t) = V (t; X, T) = H(t)E
(H)
t
_
v(X
1
(T), . . . , X
n
(T))
H(T)
_
, (A.1)
where E
(H)
t
[] denotes the conditional expectation up to time t (i.e., with respect to the
-algebra F
t
representing the information available up to time t) with respect to the H-
martingale measure. Recall the the risk-neutral expectation is dened by the money market
num eraire
B(T) := exp
_
_
T
0
r(t)dt
_
,
where r is the short rate. We denote the stochastic discount factor with
D(t, T) := exp
_

_
T
t
r(u)du
_
so that D(t, T) = B(t)/B(T). For more details on these assumptions and denitions, cf.,
e.g., [MR05, Chap. 8].
8
Asset returns or prices are dened in terms of the factors. The factors essentially model the randomness of
the market model at hand.
9
A (European) security is attainable if there exists a self-nancing strategy that replicates its value at expi-
ration. Notice we do not assume the market is complete, so that the martingale measure may not be unique.
However, we do assume that all securities considered are attainable.
12 Giuseppe Castellacci
PUT-CALL PARITY FOR EUROPEAN EXOTICS B. The Intrinsic Value of European Vanilla Options
APPENDIX B. THE INTRINSIC VALUE OF EUROPEAN VANILLA OPTIONS
In this section we clarify our notion of intrinsic value for European options with the clas-
sical example of vanilla options. The widespread notion of intrinsic value is based on the
exercise value of American vanilla options. Therefore, such value does not have economic
signicance for European options. Indeed, it is not difcult to nd scenarios in which
European options are worth less than their (American) intrinsic value. This is essentially
due to the discounting of the cash ow that would result from the exercise of the option at
expiry. A simple discounting correction provides the natural denition of the European in-
trinsic value. This can be regarded as the result of freezing the underlying price process.
For diffusive dynamics, freezing can be modeled as taking the limit of the process as the
volatility tends to zero. We proceed to illustrate this in the a simple generalization of the
Black-Scholes formula that does not assume deterministic short rates.
We assume that the T-forward price of the underlying asset, that is,
F
S
(t, T) =
S(t)
P(t, T)
, (B.1)
rather than the underlying price itself S(t), follows an exponential diffusion with determin-
istic volatility and that this process is an exponential martingale.
10
Therefore, the forward
price can be written as
F
S
(t, T) = F
S
(t
0
, T) exp
_

_
t
t0

2
(u)
2
du +
_
t
t0
(u) dW(u)
_
, (B.2)
where t
0
t T, W is Brownian motion and is the deterministic instantaneous volatil-
ity. Dene the average volatility up to time T
(T) :=
1
T t
0

_
t
t0

2
(u) du, (B.3)
and notice that the normal variable
_
T
t0
(u) dW(u) has zero expectation and variance
var
_
_
T
t0
(u) dW(u)
_
=
2
(T t
0
). (B.4)
Then, the value of a vanilla European option with strike K on the underlying asset at time
t
0
can be written as
11
10
This is consistent with assuming that the underlying asset price together with the ZCB price follow a
diffusion with deterministic dispersion. Changing the measure to the T-forward one grants the martingale nature
of forward prices. Hence the Brownian motion considered can be regarded as one in this measure (the result of
applying Girsanovs theorem).
11
For a proof in the case of constant volatility and of the option being a call, cf. [Shr04, Theorem 9.4.2]. The
case presented here is a slight generalization of that theorem, and the proof can be extended once one replace
Giuseppe Castellacci 13
B. The Intrinsic Value of European Vanilla Options PUT-CALL PARITY FOR EUROPEAN EXOTICS
V
BS
(t
0
; ) = V
BS
(t
0
; T, S, K, , ) = (S(t
0
)N(d
+
(t
0
)) KP(t
0
, T)N(d

(t
0
))) ,
(B.5)
where
d

(t
0
) = d

(t
0
; T, S, K, ) =
ln
_
F
S
(t0,T)
K
_

2
(T)(T t
0
)
(T)

T t
0
, (B.6)
and
=
_
_
_
1 if the option is a call
1 if the option is a put.
(B.7)
The result of freezing the underlying asset price process is to x it to the current value
S(t
0
). Because the option can only be exercised at maturity T, one must take into account
the future value of S(t
0
), which is F
S
(t
0
, T) = S(t
0
)/P(t
0
, T). Then the intrinsic value
of a European vanilla option can be dened as
IV (t
0
; ) := P(t
0
, T) [ (F
S
(t
0
, T) K)]
+
= [ (S(t
0
) KP(t
0
, T))]
+
. (B.8)
Next, we showthat this coincides with the limit of the option pricing formula as the average
volatility tends to zero.
12
First note that
lim
(T)0
+
d

(t
0
; T, S, K, ) =
_

_
+ if F
S
(t
0
, T) > K
0 if F
S
(t
0
, T) = K
if F
S
(t
0
, T) < K.
(B.9)
Plugging these limit values into the cumulative normal distribution, we obtain,
lim
(T)0
+
V
BS
(t
0
; T, S, K, , ) =
_
_
_
(S(t
0
) KP(t
0
, T)) if F
S
(t
0
, T) > K
0 otherwise
(B.10)
Finally, note that the condition F
S
(t
0
, T) > K can be written as S(t
0
) > KP(t
0
, T),
so that
lim
(T)0
+
V
BS
(t
0
; T, S, K, , ) = [ (S(t
0
) KP(t
0
, T))]
+
. (B.11)
Remark B.1. This formulation also suggests a European version of moneyness. A Eu-
ropean vanilla option can be dened ITM if S(t
0
) > KP(t
0
, T), ATM, if S(t
0
) =
KP(t
0
, T) and OTM if S(t
0
) < KP(t
0
, T). Essentially, a discounting correction is
applied to the traditional notion of moneyness.
the the constant with the average volatility. (The salient ingredient of that proof is the log-normality of forward
prices). Also the price of puts can be derived mimicking the derivation for calls or by put-call parity.
12
This implies that the instantaneous volatility uniformly tends to zero as a function of time.
14 Giuseppe Castellacci
PUT-CALL PARITY FOR EUROPEAN EXOTICS B. The Intrinsic Value of European Vanilla Options
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E-mail address: castel@alum.mit.edu
Giuseppe Castellacci 15