Beruflich Dokumente
Kultur Dokumente
RAVICHANDRAN
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.
2
Put-call parity
Assumptions :
1. Non dividend paying stocks
2. Option Style : European
3. call and put options - same strike price K
and the same time to maturity T.
Put Call Parity Relationship Derivation
Portfolio A
• Long one call
• Investment of PV(K) for maturity at T
(Ke -rT ) (zero coupon bond equivalent strike
price)
Portfolio C
Long one put
Long one unit of stock
Put Call Parity contd.
• The initial cost of Portfolio A is the cost of
the call plus the amount of the investment,
which is c + Ke -rT
• The initial cost of Portfolio C is the sum of
the prices of the put and the stock, which
is p + S0
At time T
• If ST < K:
• The call (right to buy) in Portfolio A is
worthless, while the investment is worth K.
• Total value of Portfolio A: K
• The put in Portfolio C is worth K − ST and
the stock is worth ST .
• Total value of Portfolio C: K
• (ie. K- ST+ ST)
At time T
• If ST ≥ K:
• The call in Portfolio A is worth ST − K and
the investment is worth K.
• Total value of Portfolio A: ST
• The put in Portfolio C is worthless, while
the stock is worth ST .
• Total value of Portfolio C: ST
• In other words : Both the Portfolios are worth
max(ST,K)
Put- Call Parity Expression
• The portfolios have identical values in all
circumstances at time T .
• Both portfolios have no interim cash flows
since there are no dividends on the stock
and the options cannot be exercised early
as they are European.
• Therefore, the initial cost of the two
portfolios must also be the same.
• We must have c + Ke -rT = p + S0
Summary
Uses of Put-Call Parity
• One of the most well-known results in
option pricing, put-call parity is also one of
the most useful.
• The first and most obvious use of the
result is in the valuation problem.
• Once we can price European calls on non-
dividend-paying assets, we can derive the
prices of the corresponding put options
Uses of Put-Call Parity
• Put-call parity can be used to check for arbitrage
opportunities resulting from relative mispricing of
calls and puts.
• For example, if we find c + Ke -rT > p + S0, then the
call is overvalued relative to the put.
• We can buy Portfolio C, sell Portfolio A, and make
an arbitrage profit.
• Conversely, if we find c + Ke -rT < p + S0, the put is
overvalued relative to the call.
• Arbitrage profits can be made by selling Portfolio C
and buying Portfolio A.
Uses of Put-Call Parity
• Third, rearranging the put-call parity expression
tells us how to create synthetic instruments
from traded ones.
• For example, since put-call parity tells us that p
= c + Ke -rT − S0,
• we can create a synthetic long put by
• buying a call, investing PV(K), and shorting
one unit of the underlying.
• Similarly we can create few other synthetic
instruments.
Uses of Put-Call Parity
• c + Ke -rT = p + S0
• Portfolio A = c + Ke -rT
• Portfolio C = p + S0
• c + Ke-rT = 3 + 30 * e- 0.1* 3/12 = $32.26
• p + S0 = 2.25 + 31= $33.25
• Portfolio C is overpriced relative to portfolio A.
• An arbitrageur can buy the securities in
portfolio A and short the securities in portfolio
C.
Arbitrage – Put Call Parity - Illustration