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Notation
c: European call option C: American call option
price price
p: European put option P: American put option
price price
S0: Stock price today ST: Stock price at option
maturity
K: Strike price
D: PV of dividends paid
T: Life of option
during life of option
s: Volatility of stock
price r Risk-free rate for
maturity T with cont.
comp.
Effect of Variables on Option Pricing (Table
11.1)
Variable c p C P
S0 + − + −
K − + − +
T ? ? + +
s + + + +
r + − + −
D − + − +
Put-Call Parity
Are call options inherently more expensive than put options?
How can we be sure the options market-place offers fair
prices for both calls and puts, even in a hectic, volatile
market environment?
The answer to these questions can be found in the concept of put call parity and
options arbitrage. The pricing relationship that exists between put and call options on
the same underlying, the same strike price and expiration date is known as put-call
parity.
Put-Call Parity
The term "put-call" parity refers to a principle that defines the relationship
between the price of European put and call options of the same class. Put simply,
this concept highlights the consistencies of these same classes.
Put and call options must have the same underlying asset, strike price, and
expiration date in order to be in the same class.
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.
The put call relationship is highly correlated, so if put call parity is violated, an
arbitrage opportunity exists.
Synthetic Relationships
With stock and options, there are six possible positions from three securities when
dividends and interest rates are equal to zero – stock, calls and puts:
1. Long Stock
2. Short Stock
3. Long Call
4. Short Call
5. Long Put
6. Short Put Original Position = Synthetic Equivalent
Long Stock = Long Call + Short Put
Short Stock = Short Call + Long Put
Long Call = Long Stock + Long Put
Short Call = Short Stock + Short Put
Long Put = Short Stock + Long Call
Short Put = Long Stock + Short Call
Synthetic Relationships
1. Exercising the option in cashless fashion (i.e. cash settlement - Speculator):
Synthetic Forward = Buying a call (c) + Selling a put (p) c = call premium
Forward P/L = Long call P/L + Short put P/L p = put premium
Spot price > Strike Price Spot price < Strike Price
(ST - K) = (ST - K) - c + (0) + p (ST - K) = (0) - c + (ST - K) + p
(ST - K) = (ST - K) – c + p (ST - K) = (ST - K) – c + p
When c = p When c ≠ p
(ST - K) = (ST - K) (ST - K) = (ST - K) – c + p
https://zerodha.com/varsity/chapter/synthetic-long-arbitrage/
Synthetic Relationships
1. Exercising the option in cashless fashion (i.e. Delivery based settlement - Hedger):
Synthetic Forward = Buying a call (c) + Selling a put (p)
Forward price i.e. -F0 or -K = -K + p – c as exercise price of underlying asset
is same for options and forward, hence
F0 = K
-S0 = -Ke-rt + p – c (equation in present value terms)
F0 = S0erT
F0 e-rt = S0 This can be written as:
c - p = So - Ke-rt
that c + Ke -rT = p + S0
Arbitrage Opportunities
Suppose that
c= 3 S0= 31
T = 0.25 r = 10%
K =30 D=0