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Effect of Variables on Option

Pricing
Variable
S0
X
T

r
D

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Bounds for European Call and Put Option


S0 c S0 - Xe -rT
Xe -rT p Xe -rT - S0
c S 0 D Xe

rT

p D Xe rT S 0

Put-Call Parity
c p = S0 Xe -rT
c p = S0 D Xe -rT
American options:
S0 - X C - P S0 - Xe -rT
S0 - D - X C - P S0 - Xe rT

Extensions of Put-Call Parity: American options


American options; D = 0: S0 - X C - P S0 - Xe -rT
Proof of S0 - X C - P:
Assume the opposite, i.e., S0 + P > C +X. Strategy
Buy Portfolio A: American call on a stock + $X in risk-free investment
Sell Portfolio C: American put on the stock + the stock
Never exercise your call earlier
If held to maturity, profit = XerT X>0
If American put is exercised earlier at time t, then
Profit = max(ST, XerT)-Xer(T-t) XerT-Xer(T-t) 0

Extensions of Put-Call Parity: American options


American options; D = 0: S0 - X C - P S0 - Xe -rT
Proof of C - P S0 - Xe -rT:
Assume the opposite, C + Xe -rT>S0 + P Strategy:
Sell Portfolio A: American call on a stock+ $Xe -rT investment
Buy Portfolio C: American put on the stock + the stock
Never exercise your put earlier
If held to maturity, payoffs are the same
If American call is exercised earlier at time t, then
Profit = max(ST,X) (ST-X(1-er(T-t))) max(ST,X) ST 0

Example: option price bounds


A four-month European call option on a dividend-paying stock is currently
selling for $5. The stock price is $64, the strike price is $60, and a
dividend of $0.80 is expected in one month. The risk-free interest rate is
12% per annum for all maturities. What opportunities are there for an
arbitrageur?
Solution:
To prevent arbitrage we must have S0 c S0 D - Xe -rT
Here c=$5, S0=$64, X=$60, r=12%, T=4/12, D=0.8*exp(-0.12*1/12)=0.79
So, we have 5<64-0.79-60*exp(-0.12*4/12)=64-0.79-57.69=5.52
Hence, arbitrage is possible

Example (continue)

A four-month European call option on a dividend-paying stock is currently selling for $5. The stock price is $64, the strike
price is $60, and a dividend of $0.80 is expected in one month. The risk-free interest rate is 12% per annum for all
maturities. What opportunities are there for an arbitrageur?
Solution:
To prevent arbitrage we must have S0 c S0 D - Xe -rT
Here c=$5, S0=$64, X=$60, r=12%, T=4/12, D=0.8*exp(-0.12*1/12)=0.79
So, we have 5<64-0.79-60*exp(-0.12*4/12)=64-0.79-57.69=5.52

We have S0 D - Xe -rT c >0.


Arbitrage strategy:
Short-sell stock, invest (D+ Xe -rT ), buy call option
At t=0: get S0 D - Xe -rT c =64-0.79-57.69-5=$0.52>0
At t=1/12: redeem 0.79*exp(0.12*1/12)=$0.80 to pay the dividend
At t=4/12: Collect $57.69*exp(0.12*4/12)=$60 from investment
If ST<$60, buy the stock at ST, close the short position in stock, cash flow = (60-ST)>0
If ST>$60, exercise the option. close the short position in stock, cash flow = (60-60)=0

Example: call-put parity


A European call option and put option on a stock both have a strike price of
$18.75 and an expiration date in three months. Both sell for $3. The riskfree 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:
To prevent arbitrage we must have c p = S0 D Xe -rT
Here c=p=$3, S0=$19, X=$18.6, r=10%, T=3/12, D=1*exp(-0.1*1/12)=0.99
So, we have 3-3>19-0.99-18.75*exp(-0.1*3/12)=19-0.79-18.29=-$0.08
Hence, arbitrage is possible

Example: (continue)
A European call option and put option on a stock both have a strike price of $18.75 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:
To prevent arbitrage we must have c p = S0 D Xe -rT
Here c=p=$3, S0=$19, X=$18.6, r=10%, T=3/12, D=1*exp(-0.1*1/12)=0.99
So, we have 3-3>19-0.99-18.75*exp(-0.1*3/12)=19-0.79-18.29=-$0.08

We have c p > S0 D Xe -rT , i.e. 0>p-c+S0 D Xe -rT


Arbitrage strategy:
Sell call, buy put, buy stock, borrow (D Xe -rT )
At t=0: get c p - S0 D Xe -rT = 3-3-19+0.99+18.29=$0.08>0
At t=1/12: get $1 dividend, use it to repay the original $0.99 of your debt [0.99*exp(0.1/12)=1]
At t=4/12: You will have a debt of $18.29*exp(0.1*3/12)=$18.75
If ST<$60, call expires, you exercise put to get $18.75 for your stock. Use it to repay the debt.
Cash flow = (18.75-18.75)=0
If ST<$60, let the put expire, call is exercised against you. You deliver the stock and receive
$18.75 for it. Use the money to repay the debt. Cash flow = (18.75-18.75)=0