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Financial Derivatives: Reference: Chapter 10, FFOM Book

The document discusses financial derivatives and options pricing. It provides upper and lower price bounds for call and put options with and without dividends. It also discusses lower bounds of European call and put prices using examples. Put-call parity is introduced as a fundamental relationship between European put and call option prices with the same underlying, strike price, and expiration. The proof of put-call parity is shown and how it can be used to identify arbitrage opportunities. An example arbitrage opportunity is provided and the correct arbitrage strategy is described. Finally, it is noted that put-call parity does not hold for American options since they can be exercised before expiration.

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69 views24 pages

Financial Derivatives: Reference: Chapter 10, FFOM Book

The document discusses financial derivatives and options pricing. It provides upper and lower price bounds for call and put options with and without dividends. It also discusses lower bounds of European call and put prices using examples. Put-call parity is introduced as a fundamental relationship between European put and call option prices with the same underlying, strike price, and expiration. The proof of put-call parity is shown and how it can be used to identify arbitrage opportunities. An example arbitrage opportunity is provided and the correct arbitrage strategy is described. Finally, it is noted that put-call parity does not hold for American options since they can be exercised before expiration.

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Financial Derivatives

Session IX
Reference: Chapter 10, FFOM Book
Upper Price Bounds for Options
c p C P
Option Price <=S0 <=Ke-rt <=S0 <=K

Lower Price Bounds for Options for non-Dividend Paying Stocks


Stock c p C P
Non-Dividend
paying Stock
>=S0-Ke-rt >=Ke-rt -S0 >=S0-Ke-rt >=K -S0
Lower Bounds of European CALL Prices
• Postulate 3: A European CALL without dividends cannot have a value lower than the difference
between the stock price and the present value of the exercise price

• Postulate 4: A European CALL with known dividends cannot have a value lower than the stock price
minus the present value of the exercise price minus the present value of the expected dividends

• (Refer to Example 10.1 in the Book)


• K=$18 ; c=$3 S0=$20 ; Rf=10% ; t= 1 Year

Transactions at timeT0 :
Short Stock @$20 & Buy Option for $3 & Invest $17 for 1 Year @ Rf interest

Transactions after 1 year on Exercise Date


If St>18 If St<18 let’s say $15
• Receive $18.79 from the $17 investment • Receive $18.79 from the $17 investment
• Exercise Option, buy Stock at $18 • Use the money to buy Stock at St of $15
• Give this stock to close short- sell position • Give this stock to close short-sell position
• NET GAIN = $18.79 - $18= $0.79 • NET GAIN = $18.79 - $15=$3.79
PRICE BOUNDS FOR PUT OPTIONS
UPPER Bounds of European PUT Prices
• Postulate 5 & 6: A European put without/with dividends cannot be
greater than or equal to the present value of the strike price

p<=Ke-rt
Lower Bounds of European PUT Prices
• Postulate 7: A European PUT without dividends cannot have a price lower than the difference
bw the present value of the strike price and the stock price
• Postulate 8: The value of European PUT with dividends cannot be lower than the present value
of strike price minus the stock price plus the present value of the known dividends
• (Refer to Example 10.3 in the Book)
K=$40 ; p=$1 S0=$37 ; Rf=5%, t=6 months

Transactions at timeT0 :
Borrow $38 for 6 months & Buy put option for $1 & Buy Stock for $37

Transactions after 1 year on Exercise Date


If St>40 let’s say $45
If St<40
• Exercise Option, sell Stock you own at $40 • Sell Stock at St of $45
• Use $38.96 to repay borrowings • Use $38.96 to repay borrowings
• NET GAIN = $40 - $38.96= $1.04 • NET GAIN = $45 - $38.96 = $6.04

SO ONE CAN MAKE RISKLESS ROFIT IF THERE IS A PUT PRICING ANOMALY


Payoff from Stock
• What is interesting is if we compare the payout from a portfolio
containing a short put and a long call with the payout from just
owning the stock:
Payoff from Stock / Options
Payout Diagram for a Long Position in IBM Stock

200

150
Stock
100
Long Call
Payoff

50

0
0 20 40 60 80 100 120 140 160
-50
Short Put

-100
Ending Stock Price
Payoff from Stock / Options
• Notice how the payoff to the options portfolio has the same
shape and slope as the stock position – just offset by some
amount?

• This is hinting at one of the most important relationships in


options theory – Put-Call parity.
PUT - CALL PARITY
Put-call parity is a fundamental relationship that must exist
between the prices of a put option and call option if both have
the same underlying, strike price and expiration date.
The relationship is derived using arbitrage arguments.
Put-Call Parity
• Relationship between prices of call and put on the
same stock with same X and T.
• Linkage between call, put, stock (underlying asset)
and risk-free bond.

• European call & put


• c + Ke-rT = S0 + p
• Intuitive idea: Buying stock and a put, and selling a call
creates a riskless strategy with fixed payoff of X at expiry
irrespective of stock price at expiry.
Put Call Parity: Proof
Consider 2 portfolios:
Portfolio A: (one European call with same strike and time to expiry plus an amount of
cash equal to Ke-rt)
Portfolio C: (one European put with same strike and time to expiry plus 1 share )

Value at Expiry
Portfolio Current value ST < K ST ≥ K
A VA= c+ Ke-rT VA(T)= K VA(T)= ST –K+K
C VC= p + S0 VC(T)= K- ST + ST VC(T)= ST

• Both portfolios payoff is worth max( ST, X)


• Because Europeans options cannot be exercised prior to expiration date. The portfolios
must have identical values today also.
c+ Ke-rT = p + S0
PUT - CALL PARITY

c+ Ke -rt = p + S0
• Put-call parity is often used as a simple test of option
pricing models.

• Any option pricing model which produces put and call prices that
do not satisfy put-call parity must be rejected as unsound. Such a
model will suggest trading opportunities where none exist.
Arbitrage Opportunities
• Suppose that
c =3 S0 = 31
T = 0.25 r = 10%
X =30 D =0

• What are the arbitrage possibilities when?


• p = 2.25
• p =1

• (Refer to Table 10.3 in the book)


c+ Xe -rt = p + S0

A C

VALUE OF PORTFOLIO "A" ?

$32.26

VALUE OF PORTFOLIO « C" ?


$33.25
BUY "A" AND SELL « C"
For p= 2.25
Portfolio B is overpriced relative to portfolio A

Portf A :c + Xe-rT = $32.26 Portf B : p + S0 = $33.25

Arbitrage : buy securities in A and sell securities in B

Buy the call and short the put and the stock...

CASH FLOW ANALYSIS…


Cash flow : -3 + 2.25 +31 = 30.25

(invested at 10% for 3months = 31.02)


Suppose the stock at expiration Suppose the stock at expiration
is greater than $30. is less than $30

Call is exercised to buy stock for $30 Put is exercised so one has to buy stock at $30

LONG THE SHARE AT $30

Cash Flow: $31.02 - $30 = $1.02 (close out the short position)
For p= 1
Portfolio A is overpriced relative to portfolio B

Portf A :c + Xe-rT = $32.26 Portf B: p + S0 = $32.00

Arbitrage : buy securities in B and sell securities in A

Buy the put and the stock and short the call

Investment of : - $31 - $1 + $3 = -$29


(29e0.10 x 0.25 = $29.73)
Suppose the stock at expiration Suppose the stock at expiration
is greater than $30. is less than $30

you get ur Call exercised Put is exercised

SHORT THE SHARE AT $30

Cash Flow: $30.00 - $29.73 = $0.27


Problem
• A European call option and put option on a stock both have a strike
price of $20 and an expiration date in three months. Both sell for $3.
The risk-free interest rate is 10% per annum, the current stock price is
$19, and a $1 dividend is expected in one month. Identify the
arbitrage opportunity open to a trader.
Solution
If the call is worth $3, put-call parity shows that the put should be
worth
= 3 + 20*e– 0.1*0.25 + 1*e– 0.1*0.08333 – 19
= $4.50

This is greater than $3. The put option is therefore undervalued


relative to the call. The correct arbitrage strategy is to buy the put,
buy the stock, and short the call and borrow money.
DOES PUT/CALL PARITY EXIST
FOR AMERICAN TYPE
OPTIONS ?

NO

WHY ?

Because American options can be exercised before


Expiration and would not be of the same value today

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