Keith Sharp

ACT370 Ch. 9
Lecture Framework
Generalized put-call parity

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 1. Already known Put-Call Parity : Portion 1
Time T
Time 0
Now worth
Buy stock and put
ST + max(0, K-ST)
S0 + P(ST, K, T)
= max(ST K)

0 1 ………… T

T: exercise date
S0 : stock price

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 2 Put-Call Parity: Portion 2

Time 0 Time T
Buy bond and call Now worth

PV0,T(K) + C(ST, K, T) K +max(0, ST - K)

= max(K, ST )

0 1 ………… T

T: exercise date
S0 : stock price

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 3. Difference of two portions

Time 0
Time T
Buy stock and put,
Now worth
sell bond and call
max(ST ,K) - max(K, ST ) = 0
S0 + P(ST, K, T)
-PV0,T(K) - C(ST, K,T)

0 1 ………… T

Since portfolio is certain to be worth zero at time T, it must be

worth zero at time 0 or else we would all want to buy or sell it, an
arbitrage argument. Hence

S0 + P(ST, K, T) - PV0,T(K) - C(ST ,K, T) = 0

and can reorder terms till looks familiar, eg:

S0 + P(ST, K,T) = PV0,T(K) + C(ST ,K, T) :standard put-call

parity

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Examp PutCall00
(DM2e-Prob09.03)
Suppose the S&R Index is 800, the continuously compounded risk-
free rate is 5%, and the dividend yield is 0%. A 1-year 815-strike
European call costs $75 and a 1-year 815-strike European put costs
$45. Consider the strategy of buying the stock, selling the 815-
strike call and buying the 815-strike put. What difference between
the call and put prices would eliminate arbitrage?

Solution PutCall00
This S+P-C portfolio is worth a certain K at expiry so should now
cost K exp(-rT).

This requires C-P= S-Kexp(-rT)=24.748

S 800
K 815
T 1
r 0.05

C‐P= 24.74802

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Examp PutCall01
(DM2e-Prob09.01)

A stock currently sells for $32.00. A 6-month call option with

strike of $35.00 has a premium of $2.27. Assuming a 4%
continuously compounded risk-free rate and a 6% continuous
dividend yield, what is the price of the associated put option?

Solution PutCall01
At time zero, need only exp(-δT) of a stock to get 1 stock at expiry
since the stock ‘breeds’ (pays dividends which can be reinvested)
at continuous rate δ:

S0 exp(-δT) + P(K,T) = K exp(-rT) + C(K,T)

(RHS and LHS both equal max(S, K) at expiry)

32* exp(-0.06*0.5) + P(35, 0.5)- 2.27 = 35 exp(-0.04*0.5)

P(35, 0.5)=5.5227

S0= 32
C0= 2.27
rcont= 0.04
delta= 0.06
T= 0.5
K= 35

S0*exp(‐delta*T)= 31.05426
Kexp(‐rcont*T)= 34.30695
PO= 5.522696

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Examp PutCall02
(DM2e-Prob09.02)
A stock currently sells for S0 = $32.00. A T=6-month call option
with strike of $30.00 has a premium of $4.29, and a T=6-month put
with the same strike has a premium of $2.64. Assume a r=0.04
continuously compounded risk-free rate and a δ continuous
dividend yield. Calculate S0 (1- exp(-δT)). (McDonald means
‘calculate S0 (1- exp(-δT)’ but in the text question he asks ‘What is
the present value of dividends payable over the next 6 months?’
which is actually a random variable depending on the price path
followed by the stock)

Solution PutCall02
At time zero, need only exp(-δT) of a stock to get 1 stock at expiry
since the stock ‘breeds’ (pays dividends which can be reinvested)
at continuous rate δ:

S0 exp(-δT) + P(K,T) = K exp(-rT) + C(K,T) (RHS and

LHS both equal max(S, K) at expiry)

S0 exp(-δT) +2.64 = 30 exp(-0.04*0.5) + 4.29

S0 - S0 exp(-δT) = 0.94404
C0= 4.29
rcont= 0.04
P00= 2.64
T= 0.5
K= 30

Kexp(‐rcont*T)= 29.40596

S0*exp(‐delta*T)= 31.05596
S0‐S0*exp(‐delta*T)= 0.94404

Sharp: ACT370 01 M091 v22 Page 7 of 29

Your call
c iss my put
p

(smilees if othher face smiles))

I own C(S
ST ,K, T))
I own P(K ,ST, T) (w
watch thhe
I gget any excess
e of
o ST ov
ver K order)

I get aany defiicit of K below

w ST

Or cann say I gget any excess of ST

over K

(ST ,K, T)
C(S T = P(K
K ,ST, T)

Coould say
y a put option
o iss just a call opttion witth the K being the
undderlying
g,

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“Y
Your call is
i my
y put”
”: stocks ST, QT

I own C(S
ST ,QT, T)
T I own P(QT ,SST, T) ((watch tthe
order))
I gget any excess
e of
o ST ov
ver QT
I get aany defiicit QT bbelow ST

Same as saying I gett any exxcess off

ST oveer QT

(ST ,QT, T) = P((QT ,ST, T)

C(S

Coould sayy a put option

o iss just a call opttion witth the uunderlyiing and
exeercise switchedd.

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G
Genera
alized
d “Pu
ut-Ca
all Parrity”: stoccks STT, QT

I nnow own
n Q0 + C(ST ,Q
, T, T) I now
w own S0 + C
C(QT ,ST, T)

At T I hav
ve QT an
nd any excess
e At T I have ST plus any exccess of
of ST over QT QT ovver ST

So at T I have
h max (QT , ST) So att T I havve max((ST, QT) same
as othher facee
.

Q0 + C(S
C T ,Q
, T, T)
T = S0 + C(Q
QT ,ST, T),
annd remember caalls bein
ng samee as putts:

Q0 + C(S
C T ,Q
, T, T)
T = S0 + P(SST ,QT, T)
(geeneralizzed put-call parrity if no
o divideends)

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Assets ST, QT paying dividends or coupons
Q0 + C(ST ,QT, T) = S0 + P(ST ,QT, T)
(generalized put-call parity if no dividends)

Now consider the possibility that the assets ST, QT are dividend-
paying stocks or coupon-paying bonds or anything paying income,
whatever it’s called. Someone owning the asset gets that income,
but someone promising to buy it in the future doesn’t. So when
considering the portfolio that will end up with an equal value to
another portfolio at time T, we need to imagine buying at time 0 a
non-income paying version of the asset for which we’ll pay e.g. S0
– PV0,T(Income from S). Hence:

Q0 – PV0,T(Income from Q) + C(ST ,QT, T)

= S0 – PV0,T(Income from S) + P(ST ,QT, T)

As usual, at time T I have max (QT , ST).

Sharp: ACT370 01 M091 v22 Page 11 of 29

 Currency Options
Can regard the ‘foreign’ currency like a dividend-paying stock,
with the dividend rate now being the foreign interest rate which
lets the foreign currency ‘reproduce’ itself. Or, and less
Americentrically, notice that e.g. what looks to a New York dealer
like a call option on the yen will look to a Tokyo dealer like a put
option on the US dollar with only a ‘scale’ difference. In other
words, the New Yorker might talk about option price per yen while
the Tokyo dealer might talk about option price per dollar.

Be particularly careful with dollar-euro or dollar-loonie situations.

Both the loonie and the euro in the last few years have fluctuated
above and below the US dollar, from a US perspective. So ‘saying
exchange rate of 0.95’ is not clear whether 0.95 or 1/0.95 is meant.

With yen (JPY=¥1=about $US 0.01) or UK pounds (‘sterling’,

GBP=£1=about $US1.60 in 2011) it’s obvious when the reciprocal
is used and we’ll use these for examples.

The P.R. Chinese yuan (‘Renminbi’, RMB, = about $0.15) is

important but not yet sufficiently freely traded to be used in
examples.

McDonald uses x as the number of USD per foreign currency unit,

r (we might use rU )for the interest rate paid on a USD account and
rF for the interest rate on an account denominated in the ‘foreign’
currency.

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 Put-Call parity for currency options
x0: time 0 spot price of e.g. yen in USD (about x0 =0.01)
1/x0: time 0 spot price of USD in yen
rU: interest rate paid on a USD account e.g. in New York
rY: interest rate on a yen account e.g. in Tokyo
K: USD value of strike price per yen

Cost of a New Yorker buying now enough yen to grow to

one yen after T years is cost of exp(-rYT) yen, which in $ is
x0*exp(-rYT). Spend this and also buy a USD-denominated
put on one yen, P(¥, K, T), total x0*exp(-rYT) + P(¥, K, T).

Alternative is to hold now an amount of USD K*exp(-rUT)

and to hold also a call on one yen, C(¥, K, T), total
K*exp(-rUT) + C(¥, K, T).

x0*exp(-rYT) + P(¥, K, T)= K*exp(-rUT) + C(¥, K, T).

where both sides at T are worth

max( ¥1, $US K)=USD max(xT, K). Recall:

S0 exp(-δT) + P(S, K, T) = K*exp(-rU T) + C(S,K ,T)

S0 +P(ST ,QT, T)= Q0 + C(ST ,QT, T) (no divs)
S0exp(-δST)+P(ST ,QT, T)= Q0exp(-δQT) + C(ST ,QT, T)
where both sides at time T are worth {max(ST, QT)}

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New York’s Call is Tokyo’s Put
x0: time 0 spot price of e.g. yen in USD (about x0 =0.01)
1/x0: time 0 spot price of USD in yen
K: USD value of strike price per yen
1/K: yen value of strike price per USD

At T the US-based call on one yen, C$ (x, K, T) is worth

USD max(0, xT - K)

If you are seeing this from Tokyo and own K yen-

denominated puts on 1 USD, with exercise price 1/K

K P¥(1/x, 1/K, T)

then at time T you will have

JPY K max(0, 1/K - 1/xT)=JPY max(0, xT – K)/xT

=USD max(0, x(T)-K)

So allowing for ‘scale’ difference K the C and P are same.

Allow also for P¥ being in yen, and convert now at time 0:
C $ (x, K, T) = x0 K P¥(1/x, 1/K, T) (9.7)

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Currency options and scale alternative method:

Another way to think of this is that in New York a call

option on one Yen is the right at time T to receive one Yen
and deliver K dollars.

In Tokyo, a put option on one dollar is the right at time T to

deliver one dollar and to receive (1/K) Yen.

So you need K of the Tokyo puts to be the same deal as the

New York call, thus the standard Tokyo put is worth (1/K)
as much as the New York call. Also, the Tokyo put is
denominated in Yen, so the Yen price of the standard Tokyo
put is (1/K)*(1/x0) times the dollar price of the standard New
York call. This gives us again

C $ (x, K, T) = x0 K P¥(1/x, 1/K, T) (9.7)

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Example CurrOpt01 (McDonald Prob09.07c)
Suppose that the dollar-denominated interest rate is 5%, the
yen-denominated interest rate is 1% (both rates are
continuously compounded), the spot exchange rate is 0.009
$/¥, and the price of a dollar-denominated European call to
buy one yen with 1 year to expiration and strike price of
$0.009 is $0.0006.
Calculate the price in Tokyo of the yen-denominated at-the-
money dollar put (repeat, put).

P¥(1/x, 1/K, T)=(C $ (x, K, T))/(x0 K)

=0.0006/(0.009*0.009) =

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 Properties: American versus European
(These slides stolen from McDonald)

An American option can be exercised at any time

A European option can only be exercised at expiration,

So an American option must always be at least as valuable as

an otherwise identical European option

CAmer(S, K, T) > CEur(S, K, T)

PAmer(S, K, T) > PEur(S, K, T)

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 Option price boundaries: Call

Call price cannot

 be negative
 exceed stock price
 be less than price implied by put-call parity using
zero for put price:

S  C Amer ( S , K , T )  CEur ( S , K , T )  max[0, PV0,T ( F0,T )  PV0,T ( K )]

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 Option price boundaries: Put

 Put price cannot

 be more than the strike price
 be less than price implied by put-call parity
using zero for put price

K  PAmer ( S , K , T )  PEur (S , K , T )  max[0, PV0,T ( K )  PV0,T ( F0,T )]

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 Early exercise of American options

 A non-dividend paying American call option should not

be exercised early, because

C Amer  CEur  ST  K
 That means, one would lose money by exercising early
instead of selling the option

 If there are dividends, it may be optimal to exercise early

e.g. so as to receive a huge (perhaps liquidating) dividend

 It may be optimal to exercise a non-dividend paying put

option early if the underlying stock price is sufficiently low, so
you can start getting interest on the K

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 Prices vs Time to expiration
 An American option (both put and call) with more
time to expiration is at least as valuable as an
American option with less time to expiration.
This is because the longer option can easily be
converted into the shorter option by exercising it
early

 A European call option on a non-dividend paying

stock will be more valuable than an otherwise
identical option with less time to expiration.

 European call options on dividend-paying stock

and European puts may be less valuable than an
otherwise identical option with less time to
expiration – may want to receive a big dividend
but cannot exercise early

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 Prices vs Different strike prices
(K1 < K2 < K3),
For both European and American options:

 A call with a low strike price is at least as valuable

as an otherwise identical call with higher strike price

C ( K1 )  C ( K 2 )
(if C(K2) expires in the money, then C(K1) expires in
even more money, in fact is worth K2-K1 more)

 A put with a high strike price is at least as valuable

as an otherwise identical put with low strike price

P( K 2 )  P( K1 )

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 Prices vs Different strike prices
(K1 < K2 < K3),
For both European and American options:

The premium difference between otherwise identical

calls with different strike prices cannot be greater than
the difference in strike prices

C ( K1 )  C ( K 2 )  K 2  K1

(≤100% probability of K2 - K1 payout difference )

The premium difference between otherwise identical

puts with different strike prices cannot be greater than
the difference in strike prices

P( K 2 )  P( K1 )  K 2  K1

(≤100% probability of K2 - K1 payout difference )

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 A
Attemptt to vio
olate
C ( K1 )  C ( K2 )  K2  K1

Caaption ab bove is saying that wee lend oout the ttime 0 ppositive cash
floow of 6 so it becomes a zero time
t 0 ccash floww. Then at exxpiry
wee get reppaid thee $6 plus intereest, but hhave to withstaand the
posssible negative
n e option
n cash fllow. Buut the tiime T cash flow w is
alwways po ositive. So the time 0 investm ment of $0 has grown: would
be nice bu ut arbitrrageurs stop thiis happeening. TThis meeans thaat a
priice situaation as in paneel A woould nevver happpen in rreality.

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 P
Pricess vs Differ
D rent strike
s e pricces: C
Conveexity
Foor both
h Europ pean and
a Am mericaan optiions: P Premiuums
deecline at
a a deecreasiing ratee for ccalls w
with proogresssively
higgher sttrike prices.
p
Foor callss, at lo
ow exeercise price,
p a dollaar highher K aalmostt
certainlyy reducces calll payoout by a dolllar. Buut at higher
exxercise price it’s less certtain sinnce stoock maay nott
exxceed K at alll, so call vallue redduces bby muuch lesss than
$1. Callls are the deecreasiing priices inn graphh:

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 Prices vs Different strike prices
(K1 < K2 < K3),
Convexity of call price with respect to strike price:
slope is less (or possibly equal) steep for high K.

C ( K1 )  C ( K 2 ) C ( K 2 )  C ( K3 )

K 2  K1 K3  K 2

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 Co
onvex
xity Violati
V ion Atttemp
pt by a Calll

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Why Tab 9.7 +4 -10 + 6 pattern of calls at K= 50, 59, 65?

If the graph of call price against K were a straight line, then the
K=59 call price would be a linear interpolation between K=50 and
K=65, hence weights 4/10 and 6/10. In fact the given (must be
wrong) K=59 call price is above that straight line. So we can make
an arbitrage profit by shorting the overpriced K=59 call and going
long the interpolated synthetic call. The correct K=59 call,
because of the required convexity, is below.

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 Convex
C xity violati
v ion atttemptt by a put:

A sstraightt line intterpolattion using the PPanel A data foor the sttrike 55 5
putt gives a strike 55 put price of o (5/20))*16+(115/20)*4 = 7. S So the
mispriced d strike 555 put ata 8 is above
a thhe straigght line and an
arbbitrage profit
p reesults frrom sho
orting thhe overppriced pput P55 and
goiing longg the co omponeents of th he lineaar interppolationn P50 andd P70.

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