Todays Class

Finish Put-Call Parity

Stocks with dividends
Examples from Chapters 3 and 9

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Chapter 3
(continued)

lecture 4 review

Synthetic Forwards
A synthetic long forward is
created when you buy a call
and sell a put on the same
underlying asset, with the
same strike price and time to
expiration
Example: buy the $1,000strike S&R call and sell the
$1,000-strike S&R put, each
with 6 months to expiration
At expiration, we pay the
strike price ($1000) to own the
asset (see page 69)

+$75.68
profit

+$1,020 index
price
+$1,000 index
price

-$95.68
profit

Figure 3.6
(compare to Figure 2.10)

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lecture 4 review

Synthetic Forwards (continued)

Purchase a forward contract

at t=0 we pay zero premium
at expiration (t),we pay the forward price (F)
So the present value of the cost is = PV(F0,t)

Purchase a synthetic forward

at t=0, as shown on the previous page, to buy a synthetic forward
requires that we pay the net option premium (i.e. the difference
between premiums for the purchased call and the written put)

at expiration (t), we pay the strike price (K)

So the present value of the cost is = Call(K,t) Put(K,t) + PV(K)

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lecture 4 review

Put-Call Parity

The net cost of buying the index using options must equal
the net cost of buying the index using a forward contract,
thus

Call(K,t) Put(K,t) = PV(F0,t K)

Call(K,t) and Put(K,t) denote the premiums of options with strike
price K and time t until expiration
PV(F0,t) is the present value of the forward price
PV(K) is the present value of the strike price

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3-

lecture 4 review

Examples of Put-Call Parity (1/4)

3.2 Suppose you short the S&R Index for $1000, short a 1000-strike put
which has a premium of $74.201. The risk-free rate is 2%.
Construct a table in the format of Table 3.1, which summarizes the payoff and profit
of this position. (how do your numbers compare to those in Table 3.1?)
Verify that your numbers matches those in Figure 3.5

Figure
3.5
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2-

Chapter 9
Put-Call Parity

IBM Option Quotes

What trends do you see?

Are October options always > June options for a given K?
Does C always decrease with increasing K?
Does P always increase with increasing K?
Do Premiums always change by less than the change in K?

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A quick note about continuous

compounding
First see Appendix in back of the book, page 854
from this understanding, and our original Put-Call Parity
formula: Call(K,t) Put(K,t) = PV(F0,t K), we can now write the
following for continuous compounding
PV(F0,t) = e-rT F0,T = S0 PV0,T (Div)
PV(K) = e-rT K
and the Parity relationship at t=0 becomes
Call(K,t) Put(K,t) = S0 e-rT K

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Examples of Put-Call Parity (2/4)

Call Put = S0 e-rT K

Example 9.1
Price of a non-dividend-paying stock = $40 with r=8%
option strike price = $40
time to expiration = 3 months
European call = $2.78
European put = $1.99

$2.78 - $1.99 = $40 $40e-0.08x0.25

Yes, this is consistent with the Put-Call Parity Equation

Why is the Call $0.79 more expensive than the Put?

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9-

Why is the Call $0.79 more expensive

than the Put?

Compare Cash Flow

Both an Outright Timing
purchase of Stock and the synthetic purchase (i.e. buy call, sell put)
gives you 1 share on day 91

With method 2, we own the stock economically, but dont pay fully until day 91
This deferral of payment is worth 3 months interest on $40 to us
(3 months interest on $40) = $40e+0.08x0.25 - $40= $0.81
PV(3 months interest on $40) = e-0.08x0.25$0.81 = $0.79
The option premiums differ by interest on the deferred payment for the stock

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9-

What happens if we have dividends?

The holder of the Forward contract or option does not

receive the dividends because they do not yet hold the
underlying asset itself

If the underlying asset is a stock and PV0,T(Div) is the

present value of the dividends payable over the life of the
option, then
PV(F0,t) = e-rT F0,T = S0 PV0,T (Div) and the Parity
relationship at t=0 becomes

Call Put = S0 PV0,T (Div) e-rT K

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Examples of Put-Call Parity (3/4)

Call Put = S0 PV0,T (Div) e-rT K
Example 9.1
Price of a non-dividend-paying stock: $40, r=8%, option strike price: $40,
time to expiration: 3 months, European call premium = $2.78, European
put premium = $1.99. Then, by Put-Call Parity we can write:
$2.78 - $1.99 = $40 $40e-0.08x0.25
Example 9.2 Same as 9.1, but now the stock pays $5 dividend just before expiration
We are told the call premium = $0.74, and the put premium = $4.85.
Thus, by Put-Call Parity we can write:

$0.74 - $4.85=($40 $5e-0.08x0.25) $40e-0.08x0.25

This is consistent with the Put-Call Parity Equation
The Call price is higher than the Put price by interest on the strike ($0.79) and
lower by the PV of the dividend ($4.90) for a net difference = -$4.11

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Examples of Put-Call Parity (4/4)

Problem 9.2
A stock currently sells for $32.00.

A 6-month call
option with a strike (K) of $30.00 has a premium of
$4.29, and a 6-month put with the same strike has a
premium of $2.64. Assume a 4%, continuously
compounded, risk-free rate.

Question - What is the present value of dividends

payable over the next 6 months?

Answer - this is a direct application of Put-Call Parity

Chapter 9 Solutions are now online
Work through them on your own and ask questions as needed

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Put-Call Parity gives us a Recipe to Create

Synthetic Instruments
To create a synthetic stock, using the Put-Call Parity
Recipe we need to
Buy the call & Sell the put
Buy T-bills with a value [PV(div) + Ke-rT]

(i.e. invest at the risk-free rate)

NOTE - The sign convention is as follows: Long Position (+) and Short Position
(-)

S0 = Call Put + PV0,T (Div) + e-rT K

interpretation: In addition to buying the call and selling

the put (which gives a synthetic long) we also need to lend
(buy a bond) of an amount = PV(dividends + strike)

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Synthetic Call
To create a synthetic long call:
Buy the put
K
Buy the stock
Sell T-bills with a value Ke-rT (borrow at the risk-free rate)

To create a synthetic short call:

Sell the put
Sell the stock

Buy T-bills with a value Ke-rT (invest at the risk-free rate)

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Synthetic Put
To create a synthetic long put:
Buy the call
K
Sell the stock
Buy T-bills with a value Ke-rT (invest at the risk-free rate)

To create a synthetic short put:

Sell the call
Buy the stock

Sell T-bills with a value Ke-rT (borrow at the risk-free rate)

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Synthetic T-bills
To create a synthetic T-bill, using the Put-Call Parity Recipe
we need to
Sell the call and Buy the put
Buy the stock
NOTE - The sign convention is as follows: Long Position (+) and Short Position
(-)

S0 - Call + Put = PV0,T (Div) + e-rT K

interpretation: We have purchased the stock and sold the synthetic
stock. This produces an instrument with no risk

The RHS tells us this instrument costs PV of the dividends and strike
and pays K + FV(div) at expiration with certainty
interpretation = This is a synthetic T-bill because it has no risk
with a positive payment at expiration

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Summary of Parity Relationships

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For Next Class

Reading

finish Chapter 9

Chapter 10, Sections 10.1, 10.2

Practice problems from the book

continue to check for updates to the Word doc online,

more problems are added as we cover new material