Advanced Financial Mathematics

Chapter 9
Parity and other option relationships
These notes are greatly inspired from the book Derivatives Markets

Chapter 9-Advanced Financial Mathematics-UEH-F2023 2

Table 9.1 in DM

Chapter 9-Advanced Financial Mathematics-UEH-F2023 3

Parity equation

• Without dividend:
𝐶𝐶 𝐾𝐾, 𝑇𝑇 − 𝑃𝑃 𝐾𝐾, 𝑇𝑇 =

• With dividend:
𝐶𝐶 𝐾𝐾, 𝑇𝑇 − 𝑃𝑃 𝐾𝐾, 𝑇𝑇 =

Chapter 9-Advanced Financial Mathematics-UEH-F2023 4

Synthetic Option
• Synthetic call option:
−𝑇𝑇
𝐶𝐶 𝐾𝐾, 𝑇𝑇 = 𝑃𝑃 𝐾𝐾, 𝑇𝑇 + 𝑆𝑆0 − 𝑉𝑉𝑉𝑉(𝑑𝑑𝑑𝑑𝑑𝑑) − 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓
• Synthetic put option :
−𝑇𝑇
𝑃𝑃 𝐾𝐾, 𝑇𝑇 = 𝐶𝐶 𝐾𝐾, 𝑇𝑇 + 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓 − 𝑆𝑆0 − 𝑃𝑃𝑃𝑃 𝑑𝑑𝑑𝑑𝑑𝑑

Chapter 9-Advanced Financial Mathematics-UEH-F2023 5

Example
An action that doesn't pay dividends is currently worth $40. The continuous interest
rate is 8%. The expiration for both call and put options is 3 months. The call option
costs $2.78, and the put option costs $1.99.

a) Find the strike price.

b) For what strike price are both options priced the same?
Solution:
a) 𝐾𝐾 =

b) 𝑃𝑃 𝐾𝐾, 𝑇𝑇 = 𝐶𝐶 𝐾𝐾, 𝑇𝑇 if K=

Observation:
Chapter 9-Advanced Financial Mathematics-UEH-F2023 6
Example 9.2 in DM
We take the same assumptions as the previous example, but this time, the stock
pays a dividend of $5 just before expiration. The put option costs $4.85, and the
strike price is $40. Calculate the price of the call option.
Solution:
𝐶𝐶 𝐾𝐾, 𝑇𝑇 =

Observation:

Chapter 9-Advanced Financial Mathematics-UEH-F2023 7

Lower and upper bounds of call option price
Lemma 9.1: In the absence of arbitrage, if the stock does not pay
dividends then
max(𝑆𝑆0 − 𝐾𝐾𝑒𝑒 −𝑟𝑟𝑇𝑇 , 0) ≤ 𝐶𝐶 𝐾𝐾, 𝑇𝑇 ≤ 𝑆𝑆0

Demonstration:

Chapter 9-Advanced Financial Mathematics-UEH-F2023 8

Demontration:
Consider 3 following strategies :
• Strategy 1: buy the call option and a zero-coupon bond that gives K at maturity. The
payoff is Vport1 = max( 𝑆𝑆𝑇𝑇 , 𝐾𝐾)
• Strategy 2: buy the stock whose payoff is Vport2 = 𝑆𝑆𝑇𝑇
• Stratégie 3: buy the call Vport3 = max( 𝑆𝑆𝑇𝑇 − 𝐾𝐾, 0)

Observe that
max( 𝑆𝑆𝑇𝑇 , 𝐾𝐾) = max( 𝑆𝑆𝑇𝑇 − 𝐾𝐾, 0) + K

max( 𝑆𝑆𝑇𝑇 , 𝐾𝐾) ≥ 𝑆𝑆𝑇𝑇 ≥ 𝑚𝑚𝑚𝑚𝑚𝑚( 𝑆𝑆𝑇𝑇 − 𝐾𝐾, 0)

In the absence of arbitrage, we must have

𝐶𝐶 𝐾𝐾, 𝑇𝑇 + 𝐾𝐾𝑒𝑒 −𝑟𝑟𝑇𝑇 ≥ 𝑆𝑆0 ≥ 𝐶𝐶 𝐾𝐾, 𝑇𝑇

Chapter 9-Advanced Financial Mathematics-UEH-F2023 9
Lower and upper bounds of put option price
Lemma 9.2: In the absence of arbitrage, if the stock does not pay
dividends then
max(𝐾𝐾𝑒𝑒 −𝑟𝑟𝑇𝑇 − 𝑆𝑆0 , 0) ≤ 𝑃𝑃 𝐾𝐾, 𝑇𝑇 ≤ 𝐾𝐾𝑒𝑒 −𝑟𝑟𝑇𝑇

Demonstration:

Chapter 9-Advanced Financial Mathematics-UEH-F2023 10

Demontration:
Consider the following 3 strategies:
• Strategy 1: Buy a put option and a stock. The value at maturity is equal to
max( 𝑆𝑆𝑇𝑇 , 𝐾𝐾)
• Strategy 2: Buy a zero-coupon bond that provides a revenue K at maturity:

• Strategy 3: Buy a put option where the value at maturity is equal to

max(𝐾𝐾 − 𝑆𝑆𝑇𝑇 , 0).
Observe that
𝑚𝑚𝑚𝑚𝑚𝑚(𝐾𝐾 − 𝑆𝑆𝑇𝑇 , 0) + 𝑆𝑆𝑇𝑇 = max( 𝑆𝑆𝑇𝑇 , 𝐾𝐾) ≥ 𝐾𝐾 ≥ 𝑚𝑚𝑚𝑚𝑚𝑚(𝐾𝐾 − 𝑆𝑆𝑇𝑇 , 0)
In the absence of arbitrage, we must have
P 𝑇𝑇, 𝐾𝐾 + 𝑆𝑆0 ≥ 𝐾𝐾𝑒𝑒 −𝑟𝑟𝑇𝑇 ≥ P 𝐾𝐾, 𝑇𝑇

Chapter 9-Advanced Financial Mathematics-UEH-F2023 11

 Parity for options on currency
• The payoff of a call option that allows to by 1*FC (euro) at price K*DC (dollar) at maturity:
𝑀𝑀𝑀𝑀𝑀𝑀 0, 𝑥𝑥𝑇𝑇 − 𝐾𝐾 .

• The payoff of a put option that allows to sell 1*DF (euro) at price K*DC (dollar) at maturity:
𝑀𝑀𝑀𝑀𝑀𝑀 0, 𝐾𝐾 −𝑥𝑥𝑇𝑇 .

• Here 𝑥𝑥𝑇𝑇 is the exchange rate DC/FC at T.

Chapter 9-Advanced Financial Mathematics-UEH-F2023 12

 Parity for currency options
Lemma 9.3: In the absence of arbitrage, the parity equation of currency options is given by

−𝑇𝑇 −𝑇𝑇
𝐶𝐶 𝑥𝑥0 , 𝐾𝐾, 𝑇𝑇 − 𝑃𝑃 𝑥𝑥0 , 𝐾𝐾, 𝑇𝑇 = 𝑥𝑥0 1 + 𝑟𝑟𝐹𝐹 − 𝐾𝐾 1 + 𝑟𝑟𝐷𝐷
Demonstration:
Transaction t=0 t=T t=T

𝑥𝑥𝑇𝑇 < 𝐾𝐾 𝑥𝑥𝑇𝑇 > 𝐾𝐾

Buy a call
Sell a put
Total
How to obtain the same value to 𝑥𝑥𝑇𝑇 − 𝐾𝐾 ∗ 𝐷𝐷𝐷𝐷 at maturity?
Chapter 9-Advanced Financial Mathematics-UEH-F2023 13
 Transaction
t=0 t=T t=T

Demonstration (cont.)
𝑥𝑥𝑇𝑇 > 𝐾𝐾
𝑥𝑥𝑇𝑇 < 𝐾𝐾
Buy a call -𝐶𝐶 𝑥𝑥0 , 𝐾𝐾, 𝑇𝑇 0 𝑥𝑥𝑇𝑇 – 𝐾𝐾
How to obtain the same value to 𝑥𝑥𝑇𝑇 − 𝐾𝐾 ∗ 𝐷𝐷𝐷𝐷 at maturity? Sell a put
+𝑃𝑃 𝑥𝑥0 , 𝐾𝐾, 𝑇𝑇 -(K-𝑥𝑥𝑇𝑇 ) 0
Total
𝐶𝐶 𝑥𝑥0 , 𝐾𝐾, 𝑇𝑇 − 𝑃𝑃 𝑥𝑥0 , 𝐾𝐾, 𝑇𝑇 𝑥𝑥𝑇𝑇 – 𝐾𝐾 𝑥𝑥𝑇𝑇 – 𝐾𝐾

• Borrow 𝐾𝐾 1 + 𝑟𝑟𝐷𝐷 −𝑇𝑇

∗ 𝐷𝐷𝐷𝐷 at t = 0 to pay back 𝐾𝐾 ∗ 𝐷𝐷𝐶𝐶 at t = T.

• 𝑥𝑥𝑇𝑇 ∗ 𝐷𝐷𝐷𝐷 at t = T is equivalent to 1*𝐹𝐹𝐹𝐹 at the same date.

• To this end, we must make an deposit of

−𝑇𝑇 −𝑇𝑇
1 + 𝑟𝑟𝐹𝐹 ∗ 𝐹𝐹𝐹𝐹 = 1 + 𝑟𝑟𝐹𝐹 ∗ 𝑥𝑥0 ∗ 𝐷𝐷𝐷𝐷 at t = 0.
=1∗𝐹𝐹𝐶𝐶 𝑎𝑎𝑎𝑎 𝑡𝑡=0

• In total :
−𝑇𝑇 −𝑇𝑇
1 + 𝑟𝑟𝐹𝐹 ∗ 𝑥𝑥0 − 𝐾𝐾 1 + 𝑟𝑟𝐷𝐷 ∗ 𝐷𝐷𝐷𝐷

• In the absence of arbitrage, the combination of buying a call option and selling a put option
(strategy in the table) and the combination of borrowing and lending as listed previously should,
be equivalent.
Chapter 9-Advanced Financial Mathematics-UEH-F2023 14
 Options on bonds
• It is possible to issue an option on a bond just like a stock (allowing the holder to buy or sell
the bond at a price strike K at a date T).
• Note that the maturity of the bond (the moment of redemption of the face value, or
principal) is different from the maturity of the bond option!
• With 𝐵𝐵0 representing the price of the bond at t = 0, we have:

−𝑇𝑇
𝐶𝐶 𝐾𝐾, 𝑇𝑇 − 𝑃𝑃 𝐾𝐾, 𝑇𝑇 = 𝐵𝐵0 − 𝑃𝑃𝑃𝑃(𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐) − 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓
• With a coupon rate of r and a face value of F, we will have:

𝑃𝑃𝑃𝑃(𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐)
−𝑇𝑇
𝐶𝐶 𝐾𝐾, 𝑇𝑇 − 𝑃𝑃 𝐾𝐾, 𝑇𝑇 = 𝐵𝐵0 − � �
𝐹𝐹𝐹𝐹 (1 + 𝑟𝑟𝑓𝑓 )−𝑡𝑡𝑖𝑖 − 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓
𝑡𝑡𝑖𝑖 <𝑇𝑇 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

Chapter 9-Advanced Financial Mathematics-UEH-F2023 15

Forward on dividends
• Dividends are often considered to be certain and known in advance to simplify calculations,
but this is not the case in practice.
• It is possible to speculate on dividends and create derivatives products based on them.
• Consider the following combination:
−𝑇𝑇
• Borrowing 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓 at t = 0
• Buying a stock at t = 0 at the initial price 𝑆𝑆0 , which pays dividends between 0 and T
• Buying a put option with a strike price K and maturity T
• Selling a call option with a strike price K and maturity T
• The initial cost of this combination is:
−𝑇𝑇
𝑆𝑆0 + 𝑃𝑃 𝐾𝐾, 𝑇𝑇 − 𝐶𝐶 𝐾𝐾, 𝑇𝑇 − 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓

Chapter 9-Advanced Financial Mathematics-UEH-F2023 16

Forward on dividends
• The stock purchased at t = 0 has provided us with dividends before the maturity T.
• The value at maturity of this strategy is:

𝑆𝑆𝑇𝑇 + 𝐹𝐹𝑉𝑉(𝑑𝑑𝑑𝑑𝑑𝑑) − 𝐾𝐾 + 𝐾𝐾 − 𝑆𝑆𝑇𝑇 = 𝐹𝐹𝑉𝑉(𝑑𝑑𝑑𝑑𝑑𝑑)

• The accumulation of these dividends, i.e., their future value FV(𝑑𝑑𝑖𝑖𝑣𝑣), is therefore the
value at maturity associated with a forward on dividends.

• With the initial cost found earlier, we obtain:

𝑃𝑃 −𝑇𝑇
𝐹𝐹0,𝑇𝑇 (𝑑𝑑𝑑𝑑𝑑𝑑) = 𝑆𝑆0 + 𝑃𝑃 𝐾𝐾, 𝑇𝑇 − 𝐶𝐶 𝐾𝐾, 𝑇𝑇 − 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓
𝑃𝑃 𝑇𝑇
• Since 𝐹𝐹0,𝑇𝑇 𝑑𝑑𝑑𝑑𝑑𝑑 = 𝐹𝐹0,𝑇𝑇 𝑑𝑑𝑑𝑑𝑑𝑑 1 + 𝑟𝑟𝑓𝑓 , we obtain

𝑇𝑇
𝐹𝐹0,𝑇𝑇 𝑑𝑑𝑑𝑑𝑑𝑑 = 𝑆𝑆0 + 𝑃𝑃 𝐾𝐾, 𝑇𝑇 − 𝐶𝐶 𝐾𝐾, 𝑇𝑇 1 + 𝑟𝑟𝑓𝑓 − 𝐾𝐾

Chapter 9-Advanced Financial Mathematics-UEH-F2023 17

Generalized Parity and exchange options

An exchange option is a contract that allows to exchange a first security (S) for a
second security (Q) at maturity.

Examples:
• A call option that allows to buy a share of the first stock at price of the second
stock Q at maturity T. The payoff is given by

• A put option that allows to sell a share of the first stock at price of the second
stock Q at maturity T. The payoff is given by

Chapter 9-Advanced Financial Mathematics-UEH-F2023 18

Exchange options: notations
• The value at time t of the underlying asset (security S) is still denoted as 𝑆𝑆𝑡𝑡 .
• The price of a forward contract prepared at time t and with a maturity at T on
𝑃𝑃
security S is denoted as 𝐹𝐹𝑡𝑡,𝑇𝑇 𝑆𝑆
• The value at time t of the exercise price (security Q) is denoted as 𝑄𝑄𝑡𝑡 .
• The price of a forward contract prepared at time t and with a maturity at T on
𝑃𝑃
security Q is denoted as 𝐹𝐹𝑡𝑡,𝑇𝑇 𝑄𝑄
• 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑡𝑡 , 𝑄𝑄𝑡𝑡 , 𝑇𝑇 − 𝑡𝑡 is the price of a call option that allows the purchase of
security S at the price of security Q at maturity T.
• 𝑃𝑃𝑃𝑃𝑃𝑃 𝑆𝑆𝑡𝑡 , 𝑄𝑄𝑡𝑡 , 𝑇𝑇 − 𝑡𝑡 is the price of the put option that allows the sale of
security S at the price of security Q at maturity T.

Chapter 9-Advanced Financial Mathematics-UEH-F2023 19

Parity equation for exchange options
Lemma 9.4: In the absenace of arbitrage, the parity equation for
exchange options is given by
𝑃𝑃 𝑃𝑃
𝐶𝐶 𝑆𝑆𝑡𝑡 , 𝑄𝑄𝑡𝑡 , 𝑇𝑇 − 𝑡𝑡 − 𝑃𝑃 𝑆𝑆𝑡𝑡 , 𝑄𝑄𝑡𝑡 , 𝑇𝑇 − 𝑡𝑡 = 𝐹𝐹𝑡𝑡,𝑇𝑇 𝑆𝑆 − 𝐹𝐹𝑡𝑡,𝑇𝑇 𝑄𝑄

Chapter 9-Advanced Financial Mathematics-UEH-F2023 20

Demonstration
• Consider the following strategy:
Transaction t=0 t=T t=T
𝑆𝑆𝑇𝑇 < 𝑄𝑄𝑇𝑇 𝑆𝑆𝑇𝑇 > 𝑄𝑄𝑇𝑇
Buy a call
Sell a put
Sell a prepaid forward on stock S
Buy a prepaid forward on stock Q

Total

Chapter 9-Advanced Financial Mathematics-UEH-F2023 21

Example 9.3 in DM
Consider 2 stocks not paying dividends, S and Q. Suppose that the stock prices
today are $20 and $25, respectively.
Calculate the difference between the price of the call option (allowing the purchase
of stock S at the price of stock Q at maturity T) and that of the put option (allowing
the sale of stock S at the price of stock Q at maturity T).

Chapter 9-Advanced Financial Mathematics-UEH-F2023 22

Remarks
• The ability to buy stock S at the price of stock Q is equivalent to being able to sell
stock Q at the price of stock S (which will interest us only if 𝑆𝑆_𝑇𝑇 > 𝑄𝑄_𝑇𝑇).
• Thus, we will have:
𝐶𝐶 𝑆𝑆𝑡𝑡 , 𝑄𝑄𝑡𝑡 , 𝑇𝑇 − 𝑡𝑡 = 𝑃𝑃 𝑄𝑄𝑡𝑡 , 𝑆𝑆𝑡𝑡 , 𝑇𝑇 − 𝑡𝑡
• Therefore, defining "the underlying" versus "the exercise price" is somewhat
abstract in this type of contract.

Chapter 9-Advanced Financial Mathematics-UEH-F2023 23

 Parity of currency options
• Options to buy and sell currencies are indeed exchange options since they involve
exchanging one currency (local or domestic) for another (foreign) currency.
• In this context, the underlying asset is the foreign currency, and the exercise price is the
local currency by default.

• Just as with exchange options, where the purchase and sale options can be equivalent by
reversing the securities and their respective positions, you can apply the same logic to
reverse a currency option.

Chapter 9-Advanced Financial Mathematics-UEH-F2023 24

Currency options: notations
• Let 𝑥𝑥0 be the exchange rate at time zero, which means that you have to pay 𝑥𝑥0 ∗
𝑫𝑫𝑪𝑪 to obtain one unit of 𝑭𝑭𝑭𝑭.
1
• Or, we must pay 𝑭𝑭𝑭𝑭 to obtain one unit of DC.
𝑥𝑥0
• The underlying asset will always be a single unit of a specific currency by default
in all cases.

• If the option is labeled in DC, the underlying is 1*FC but the entire evaluation
is done in currency DC.

• If the option is labeled in FC, the underlying is 1*DC but the entire evaluation
is done in currency FC.

Chapter 9-Advanced Financial Mathematics-UEH-F2023 25

Currency options: notations (cont.)
• We will denote a foreign currency call option, whose price is expressed in domestic
currency as:
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐷𝐷𝐶𝐶 𝑥𝑥0 , 𝐾𝐾, 𝑇𝑇
• This foreign currency call option allows us to buy 1 unit of foreign currency
(FC) for K units of domestic currency (DC) at maturity T.
• The denomination "DC" implies that the price of this option is expressed in DC.

• It's important to note that the underlying asset here is FC since the exchange
rate 𝑥𝑥0 implies the purchase of foreign currency and not the other way
around.
• We will exercise the option only if 𝑥𝑥 𝑇𝑇 > 𝐾𝐾.

Chapter 9-Advanced Financial Mathematics-UEH-F2023 26

Parity of currency options
Lemma 9.5: In the absence of arbitrage,
1 1
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐷𝐷𝐶𝐶 𝑥𝑥0 , 𝐾𝐾, 𝑇𝑇 = 𝐾𝐾 ∗ 𝒙𝒙𝟎𝟎 ∗ 𝑃𝑃𝑃𝑃𝑃𝑃𝑭𝑭𝑭𝑭 , , 𝑇𝑇
𝑥𝑥0 𝐾𝐾

Chapter 9-Advanced Financial Mathematics-UEH-F2023 27

 Demonstration
Transaction t=0 𝑥𝑥𝑇𝑇 < 𝐾𝐾 𝑥𝑥𝑇𝑇 > 𝐾𝐾
Buy• aPour
CallDCillustrer cette dernière
−𝐶𝐶all 𝐷𝐷𝐶𝐶 𝑥𝑥0 , égalité,
𝐾𝐾, 𝑇𝑇 observons0 la stratégie
+1 ∗suivante
FC – 𝐾𝐾 ∗ :𝐃𝐃𝑪𝑪
Sell K PutFC
1 1
+ 𝐾𝐾 ∗ 𝑃𝑃ut FC , , 𝑇𝑇 1
𝑥𝑥0 𝐾𝐾 −𝐾𝐾 ∗ FC − 1 ∗ 𝐷𝐷𝐶𝐶
0 𝐾𝐾
1 1
=𝐾𝐾∗𝑥𝑥0 ∗𝑃𝑃utFC 𝑥𝑥 ,𝐾𝐾 ,𝑇𝑇
0 =−1∗FC+𝐾𝐾∗𝐷𝐷C
in local currency (DC)
Total −𝐶𝐶all𝐷𝐷C 𝑥𝑥0 , 𝐾𝐾, 𝑇𝑇
1 1 0 0
+𝐾𝐾 ∗ 𝑥𝑥0 ∗ 𝑃𝑃ut 𝐹𝐹𝐹𝐹 , , 𝑇𝑇
𝑥𝑥0 𝐾𝐾

Chapter 9-Advanced Financial Mathematics-UEH-F2023 28

Table 9.3 in DM

Chapter 9-Advanced Financial Mathematics-UEH-F2023 29

 American call options

• In general, an American option costs as much or more than a European option

𝐶𝐶𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐾𝐾, 𝑇𝑇 ≥ 𝐶𝐶𝐸𝐸𝑢𝑢𝑢𝑢 𝐾𝐾, 𝑇𝑇
𝑃𝑃𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐾𝐾, 𝑇𝑇 ≥ 𝑃𝑃𝐸𝐸𝑢𝑢𝑢𝑢 𝐾𝐾, 𝑇𝑇
• In many cases, it is worth as much as a European option.
• It may sometimes be advantageous to exercise an American call option early in
the case where the underlying asset pays dividends.
• In the absence of dividends, it will be assumed that the costs for these two types
of call options are equal, and in the presence of dividends, we will have that:
𝐶𝐶𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 > 𝐶𝐶𝐸𝐸𝐸𝐸𝐸𝐸 .

Chapter 9-Advanced Financial Mathematics-UEH-F2023 30

Comparison of american call options
Lemme 9.6: In the absence of dividends,

𝐶𝐶𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆𝑡𝑡 , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡 ≥ 𝐶𝐶𝐸𝐸𝐸𝐸𝐸𝐸 𝑆𝑆𝑡𝑡 , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡 ≥ 𝑆𝑆𝑡𝑡 − 𝐾𝐾𝑒𝑒 −𝑟𝑟 𝑇𝑇−𝑡𝑡 > 𝑆𝑆𝑡𝑡 − 𝐾𝐾

Conclusion: It is not optimal to exercise a call option before its expiration.

Two reasons why an American call option on a non-dividend-paying stock is not exercised
prematurely:
• The insurance it provides:
• Time value of money:

Chapter 9-Advanced Financial Mathematics-UEH-F2023 31

Demonstration: Table 9.4 in DM

Chapter 9-Advanced Financial Mathematics-UEH-F2023 32

With fixed dividends
• Let's assume that fixed dividends are paid with the underlying asset. We will revisit
the dividend parity equation for a general case evaluated at time t, which is:

−(𝑇𝑇−𝑡𝑡)
𝐶𝐶 𝑆𝑆𝑡𝑡 , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡 − 𝑃𝑃 𝑆𝑆𝑡𝑡 , 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡 = 𝑆𝑆𝑡𝑡 − 𝑃𝑃𝑉𝑉𝑡𝑡,𝑇𝑇 (𝑑𝑑𝑑𝑑𝑑𝑑) − 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓
between t and T

• The exercise of the call option will not be optimal if:

− 𝑇𝑇−𝑡𝑡
𝐾𝐾 − 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓 > 𝑃𝑃𝑉𝑉𝑡𝑡,𝑇𝑇 (𝑑𝑑𝑑𝑑𝑑𝑑)

Chapter 9-Advanced Financial Mathematics-UEH-F2023 33

Example
The current stock price is $100. You own an American call option with a strike price
of $90. The expiration is in one month, and a dividend of $99.99 will be paid just
before expiration.
What is the optimal strategy for you?

Chapter 9-Advanced Financial Mathematics-UEH-F2023 34

Solution
• If you exercise the option before the dividend payment, you pay $90 to receive
the $99.99 dividend. As a result, you gain $9.99 at expiration because the stock is
now worth $0.01 (due to the dividend reduction).
• If you had waited until expiration, you wouldn't have access to the dividend, and
the option couldn't be exercised (as $0.01 is less than $90)."

Chapter 9-Advanced Financial Mathematics-UEH-F2023 35

 American put options
• Recall the parity equation
−(𝑇𝑇−𝑡𝑡)
𝐶𝐶 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡 − 𝑃𝑃 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡 = 𝑆𝑆𝑡𝑡 − 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓
• The american put option should not early exercised if 𝑃𝑃 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡 > 𝐾𝐾 − 𝑆𝑆𝑡𝑡 ,
which implies
− 𝑇𝑇−𝑡𝑡
𝐶𝐶 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡 − 𝑆𝑆𝑡𝑡 + 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓 > 𝐾𝐾 − 𝑆𝑆𝑡𝑡
− 𝑇𝑇−𝑡𝑡
⇔ 𝐶𝐶 𝐾𝐾, 𝑇𝑇 − 𝑡𝑡 > 𝐾𝐾 − 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓

Chapter 9-Advanced Financial Mathematics-UEH-F2023 36

Lower bounds and upper bounds
• The option price should be strictly positive

𝐶𝐶 𝐾𝐾, 𝑇𝑇 > 0 𝑎𝑎𝑎𝑎𝑎𝑎 𝑃𝑃 𝐾𝐾, 𝑇𝑇 > 0

• The price of a call option cannot exceed the initial value of the underlying asset.
𝐶𝐶 𝐾𝐾, 𝑇𝑇 ≤ 𝑆𝑆0 𝑎𝑎𝑎𝑎𝑎𝑎 𝑃𝑃 𝐾𝐾, 𝑇𝑇 ≤ 𝐾𝐾

• From the parity relationship, we have

−𝑇𝑇
𝐶𝐶 𝐾𝐾, 𝑇𝑇 ≥ 𝑆𝑆0 − 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓 𝑎𝑎𝑎𝑎𝑎𝑎
−𝑇𝑇
𝑃𝑃 𝐾𝐾, 𝑇𝑇 ≥ 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓 − 𝑆𝑆0

Chapter 9-Advanced Financial Mathematics-UEH-F2023 37

Lower bounds and upper bounds (cont.)
Lemma 9.7:
−𝑇𝑇
(i) 𝑆𝑆0 ≥ 𝐶𝐶𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐾𝐾, 𝑇𝑇 ≥ 𝐶𝐶𝐸𝐸𝐸𝐸𝐸𝐸 𝐾𝐾, 𝑇𝑇 ≥ 𝑀𝑀𝑀𝑀𝑀𝑀 0, 𝑆𝑆0 − 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓
(ii) 𝐶𝐶𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐾𝐾, 𝑇𝑇 ≥ 𝑆𝑆0 − 𝐾𝐾
−𝑇𝑇
(iii) 𝐾𝐾 ≥ 𝑃𝑃𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐾𝐾, 𝑇𝑇 ≥ 𝑃𝑃𝐸𝐸𝐸𝐸𝐸𝐸 𝐾𝐾, 𝑇𝑇 ≥ 𝑀𝑀𝑀𝑀𝑀𝑀 0, 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓 − 𝑆𝑆0
(iv) 𝑃𝑃𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐾𝐾, 𝑇𝑇 ≥ 𝐾𝐾 − 𝑆𝑆0

Chapter 9-Advanced Financial Mathematics-UEH-F2023 38

Time to maturity

Proposition: For 𝑇𝑇1 < 𝑇𝑇2 , we have:

𝐶𝐶𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐾𝐾, 𝑇𝑇1 ≤ 𝐶𝐶𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐾𝐾, 𝑇𝑇2
𝑃𝑃𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐾𝐾, 𝑇𝑇1 ≤ 𝑃𝑃𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐾𝐾, 𝑇𝑇2

Chapter 9-Advanced Financial Mathematics-UEH-F2023 39

 Time to maturity of european call options
without dividends
Proposition: For 𝑇𝑇1 < 𝑇𝑇2 , we have

𝐶𝐶𝐸𝐸𝐸𝐸𝐸𝐸 𝐾𝐾, 𝑇𝑇1 ≤ 𝐶𝐶𝐸𝐸𝐸𝐸𝐸𝐸 𝐾𝐾, 𝑇𝑇2

Chapter 9-Advanced Financial Mathematics-UEH-F2023 40

Strike price
Lemma 9.8: For 𝐾𝐾1 < 𝐾𝐾2 , we have :
𝐶𝐶 𝐾𝐾1 , 𝑇𝑇 > 𝐶𝐶 𝐾𝐾2 , 𝑇𝑇
𝑃𝑃 𝐾𝐾1 , 𝑇𝑇 < 𝑃𝑃 𝐾𝐾2 , 𝑇𝑇
for both european and american options.

Chapter 9-Advanced Financial Mathematics-UEH-F2023 41

When the strike is time-dependent (call
option).
𝑡𝑡
Lemme 9.9: Let 𝐾𝐾𝑡𝑡 = 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓 = 𝐾𝐾𝑒𝑒 𝑟𝑟𝑟𝑟 . For european call options and for t
< T, we have:
𝐶𝐶(𝐾𝐾𝑡𝑡 , 𝑡𝑡) ≤ 𝐶𝐶(𝐾𝐾𝑇𝑇 , 𝑇𝑇)
Demonstration:

Chapter 9-Advanced Financial Mathematics-UEH-F2023 42

 Demonstration:
Consider the following strategy
• Buy a 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶(𝐾𝐾𝑇𝑇 , 𝑇𝑇)
• Sell a 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶(𝐾𝐾𝑡𝑡 , 𝑡𝑡)
• Borrow 𝐾𝐾𝑡𝑡 at t if 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶(𝐾𝐾𝑡𝑡 , 𝑡𝑡) is exercised
• Sell the underlying 𝑆𝑆𝑡𝑡 if 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶(𝐾𝐾𝑡𝑡 , 𝑡𝑡) is exercised

Chapter 9-Advanced Financial Mathematics-UEH-F2023 43

When the strike is time-dependent (put options)
𝑡𝑡
Lemma 9.10: 𝐿𝐿𝐿𝐿𝐿𝐿 𝐾𝐾𝑡𝑡 = 𝐾𝐾 1 + 𝑟𝑟𝑓𝑓 = 𝐾𝐾𝑒𝑒 𝑟𝑟𝑟𝑟 . For european put options we
have
𝑃𝑃(𝐾𝐾𝑡𝑡 , 𝑡𝑡) ≤ 𝑃𝑃(𝐾𝐾𝑇𝑇 , 𝑇𝑇)
Demonstration: :

Chapter 9-Advanced Financial Mathematics-UEH-F2023 44

Demonstration
• Buy 𝑃𝑃𝑃𝑃𝑃𝑃(𝐾𝐾𝑇𝑇 , 𝑇𝑇)
• Sell 𝑃𝑃𝑃𝑃𝑃𝑃(𝐾𝐾𝑡𝑡 , 𝑡𝑡)
• Deposit of 𝐾𝐾𝑡𝑡 at t if 𝑃𝑃𝑃𝑃𝑃𝑃(𝐾𝐾𝑡𝑡 , 𝑡𝑡) is exercised
• Buy the underlying 𝑆𝑆𝑡𝑡 si 𝑃𝑃𝑃𝑃𝑃𝑃(𝐾𝐾𝑡𝑡 , 𝑡𝑡) is exercised.

Chapter 9-Advanced Financial Mathematics-UEH-F2023 45