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Lecture 3:

No-Arbitrage Bounds on Options

Deriving pricing formulas for options is more difficult


than for forwards/futures. To price an option we
have to make assumptions about the behavior of the
underlying security’s prices (wait for Lecture 6). We can,
however, derive some general restrictions on option
prices utilizing the no-arbitrage principle.

I. Notation

II. “Intuitive” Relations

III. No-Arbitrage Bounds


A. All Stock Options
B. Options on Non Dividend Paying Stocks
C. Options on Dividend Paying Stocks

IV. Put-Call Parity


A. Options on Non Dividend Paying Stocks
B. Options on Dividend Paying Stocks
No-Arbitrage Bounds on Options

I. Notation

Current date: t
Maturity (or expiration) date: T
Price of the underlying asset: S(t ) D S
Strike (or exercise) price: K
Price of $1 bond maturing at T : B(t, T ) D B
= PV($1)
= e r(t,T )(T t)
 (T t )
= 1 C R(t, T )
Value of a European call option: c (S, K, t, T )
Value of an American call option: C (S, K, t, T )
Value of a European put option: p (S, K, t, T )
Value of an American put option: P (S, K, t, T )

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No-Arbitrage Bounds on Options

II. Intuitive Relations

How does the price of an option change when we


increase one of its inputs but keep all others fixed?

Euro. Euro. Amer. Amer.


Input Call Put Call Put
Stock Price
Dividend Yield
Strike Price
Time to Expiration
Risk-Free Rate
Volatility

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No-Arbitrage Bounds on Options

III. No-Arbitrage Bounds

A. All Stock Options


The following restrictions hold for all stock options,
regardless of whether the underlying stock pays
dividends.

1. A call option is never worth more than the stock

C (S (t ), K, t, T )  S (t )
c(S (t ), K, t, T )  S (t )

2. A put option is never worth more than the strike

P (S (t ), K, t, T )  K
p(S (t ), K, t, T )  K

Why?

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No-Arbitrage Bounds on Options

3. Options never have negative value (why?)

c(S , K, t, T )  0
C (S , K, t, T )  0
p(S , K, t, T )  0
P (S , K, t, T )  0

4. A European put option is never worth more than


the present value of the strike price (why?)

p(S , K, t, T )  K  B(t, T )

5. American options are at least as valuable as


European options (why?)

C (S , K, t, T )  c(S , K, t, T )
P (S , K, t, T )  p(S , K, t, T )

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No-Arbitrage Bounds on Options

6. American options with more time to maturity are


at least as valuable as the same options with
less time to maturity. For T2 > T1:

C (S , K, t, T2 )  C (S , K, t, T1)
P (S , K, t, T2 )  P (S , K, t, T1)

7. An American options as at least as valuable as


its “intrinsic value” (i.e., its exercise value)

C (S (t ), K, t, T )  max[0, S (t ) K]
P (S (t ), K, t, T )  max[0, K S (t )]

Bounds 6 and 7 don’t always hold for European


options.

 Why?

– Counter-examples?

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No-Arbitrage Bounds on Options

B. Options on Non Dividend Paying Stocks


The following restrictions hold only if the underlying
stock does not pay dividends.

1. The price of a call option satisfies:

c(S (t ), K, t, T )  max[0, S (t ) K  B(t, T )]


C (S (t ), K, t, T )  max[0, S (t ) K  B(t, T )]

 European call options are always worth more


than long forward positions with same price K
and maturity T .
– By NA (see next page).
– The value of a long forward position is

S (t ) K  B(t, T ).

The second inequality holds because C  c.


How does the second inequal comp. with 7?
 Why the difference?

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No-Arbitrage Bounds on Options

Proof
We only need to show that:

c(S , K, t, T )  S K  B(t, T )

 What if c < S KB?

Transaction Payoff at t Payoff at T

 What if c > S KB?

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No-Arbitrage Bounds on Options

2. The price of a European put option satisfies:

p(S , K, t, T )  max[0, K  B S]

European put options are always worth more


than short forward positions with same price K
and maturity T .
Value of a short forward: K  B(t, T ) S (t ).

Proof
Essentially the same no-arbitrage argument as
for calls.

How does the inequality compare with 7?


 Again, why the difference?

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No-Arbitrage Bounds on Options

3. Combined, A.1 and B.1 imply that the value of a


European call option on a non dividend paying
stock lies within the shaded region:

S (t )  c  max[0, S (t ) K  B(t, T )]

C(t)

0 K·B(t,T) S(t)

What would the shaded region for an American


call option look like?

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No-Arbitrage Bounds on Options

4. Combined, A.4 and B.2 imply that the value of


a European put option on a non dividend paying
stock lies within the shaded region:

K  B(t, T )  p  max[0, K  B(t, T ) S (t )]

P(t)
K·B(t,T)

0 K·B(t,T) S(t)

What would the shaded region for an American put


option look like?
 Hint: look at A.2

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No-Arbitrage Bounds on Options

C. Options on Dividend Paying Stocks


Prices of put and call options on a stock that pays
a known dividend D satisfy:

C  c  S (t ) PV(D) KB
P p KB S (t ) C PV(D)

Intuition:
 The value of a call (put) option is greater than
that of a long (short) position in a forward with
price K and maturity T .
 That is, the value of an option is greater than
the PV of the cash-flow if the holder always
exercises at maturity.
 The cash-flow of a long position in a forward is
S (T ) K. Its PV is S (t ) PV(D) K  B.
 The cash-flow of a short position in a forward is
K S (T ). Its PV is K  B S (t ) C PV(D).

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No-Arbitrage Bounds on Options

IV. Put-Call Parity


A. Non Dividend Paying Stocks
The prices of European put and call options on a
non-dividend paying stock must satisfy

c(S , K, t, T ) p(S , K, t, T ) D S (t ) K  B(t, T )

 This rule is called put-call parity.


 It’s a NA relationship.
– A violation of p-c parity implies an arbitrage
opportunity.

Intuition: The two portfolios


1. long a European call and short a European
put, both struck at K, and
2. a long forward with delivery price K,

have exactly the same future payoffs. They must,


therefore, have the same values today.

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No-Arbitrage Bounds on Options

Payoffs

Payoff

K S(T)

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No-Arbitrage Bounds on Options

Arbitrage Example: Suppose that:


 S D $50,
 r D 5%,
 T t D 1 year,
and at-the-money puts and calls are both selling
for $4. Is there an arbitrage opportunity?
Yes! There must be; put-call-parity is violated:
c p D 0
6D 2.44
D S KB

Payoff at T
Transaction Payoff at t S(T ) < K S(T ) > K

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No-Arbitrage Bounds on Options

Which is worth more, an ATM call or put?


 Assume no dividend

First, for what K should cK D pK ?


 A put minus a call is a synthetic forward
 So is costless if the delivery price (strike) is the
forward price.
– and F(t, T ) D S (t )=B(t, T )
 That is, CS =B D PS =B

The forward price is above the spot

F(t, T ) D S (t )=B(t, T ) > S (t )

 Calls are worth more at lower strikes


 Puts are worth less at lower strikes

So
CS > CF D PF > PS

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No-Arbitrage Bounds on Options

B. Dividend Paying Stocks


Put-Call Parity still holds: a long call and a
short put is a “synthetic” forward. With dividends,
though, the price of the forward is different.

The prices of European put and call options on a


stock that pays a known dividend D must satisfy

c p D F(S (t ), K, t, T ))
D S (t ) P V (D) K  B(t, T ).

The prices of European put and call options on a


stock that pays a dividend yield ı must satisfy

c p D F(S (t ), K, t, T ))
ı(T t)
D S (t )e K  B(t, T ).

The prices of American put and call options on a


stock that pays a known dividend D must satisfy:

S (t ) K  B(t, T )  C P
 S (t ) P V (D) K

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No-Arbitrage Bounds on Options

Proof: To prove this last expression we must show


that we can make “arbitrage profits” if either of the
inequalities are violated.

 If C P >S K  B:

Payoff at Payoff at T
Transaction t tD S(T ) < K S(T ) > K

 If C P <S P V (D) K:

Payoff at Payoff at T
Transaction t tD S(T ) < K S(T ) > K

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No-Arbitrage Bounds on Options

We just showed that there are arbitrages if the


portfolios are held to maturity.

Question: What happens in each case if the


written option is exercised against you early?

 In the first case, you’re short the call. If the call


is exercised against you, you:
– Probably won’t get the dividend (bad, but it
doesn’t kill the arbitrage)
– You cover your short bond position early (good:
it’s trading below face)
– You’ll still own the put (good: it may still pay off)

 In the second case, you’re short the put. If it’s


exercised against you, you:
– Your bonds wont be worth as much (bad, but it
doesn’t kill the arbitrage)
– You might not have to pay the dividend (good)
– You still own the call (good: it may still pay off)

What if you exercise early?

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