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Pricing

Variable

S0

X

T

r

D

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+

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

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

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

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

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

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

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

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