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Solutions

The document is a chapter from a book titled "Solutions and Proofs: American Options" by J. Robert Buchanan. It contains proofs of several inequalities and equalities related to pricing American options, including: 1) Parity I proves that the price of an American call plus the strike price cannot be less than the price of the underlying security plus the price of an American put. 2) Another Inequality I proves that the price of an American call cannot be less than the price of the underlying security plus the price of an American put plus the discounted strike price. 3) A Surprising Equality I proves that the price of an American call cannot be greater than the price of a European call

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475 views6 pages

Solutions

The document is a chapter from a book titled "Solutions and Proofs: American Options" by J. Robert Buchanan. It contains proofs of several inequalities and equalities related to pricing American options, including: 1) Parity I proves that the price of an American call plus the strike price cannot be less than the price of the underlying security plus the price of an American put. 2) Another Inequality I proves that the price of an American call cannot be less than the price of the underlying security plus the price of an American put plus the discounted strike price. 3) A Surprising Equality I proves that the price of an American call cannot be greater than the price of a European call

Uploaded by

Amsalu Walelign
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Solutions and Proofs: American Options

An Undergraduate Introduction to Financial Mathematics

J. Robert Buchanan

J. Robert Buchanan

Solutions and Proofs: American Options

Parity I
Proof: Assume to the contrary that C a + K < S + P a . Sell the security, sell the put, and buy the call. This produces a cash ow of S + P a C a . Invest this amount at the risk-free rate, If the owner of the American put chooses to exercise it at time 0 t T , the call option can be exercised to purchase the security for K . The net balance of the investment is (S + P a C a )ert K > Kert K 0. If the American put expires out of the money, exercise the call to close the short position in the security at time T . The net balance of the investment is (S + P a C a )erT K > KerT K > 0.
J. Robert Buchanan Solutions and Proofs: American Options

Parity II

Thus the investor receives a non-negative prot in either case, violating the principle of no arbitrage.

J. Robert Buchanan

Solutions and Proofs: American Options

Another Inequality I
Proof: Suppose S + P a < C a + KerT . Sell an American call and buy the security and the American put. Thus C a S P a is borrowed at t = 0. If the owner of the call decides to exercise it at any time 0 t T , sell the security for the strike price K by exercising the put. The amount of loan to be repaid is (C a S P a )ert and (C a S P a )ert + K = (C a + Kert S P a )ert (C a + KerT S P a )ert since r > 0. By assumption S + Pa < Ca + KerT , so the last expression above is positive.

J. Robert Buchanan

Solutions and Proofs: American Options

A Surprising Equality I
Proof: Suppose that C a > C e . Sell the American call and buy a European call with the same strike price K , expiry date T , and underlying security. The net cash ow C a C e > 0 would be invested at the risk-free rate r . If the owner of the American call chooses to exercise the option at some time t T , sell short a share of the security for amount K and add the proceeds to the amount invested at the risk-free rate. At time T close out the short position in the security by exercising the European option. The amount due is (C a C e )erT + K (er (T t ) 1) > 0.

J. Robert Buchanan

Solutions and Proofs: American Options

A Surprising Equality II

If the American option is not exercised, the European option can be allowed to expire and the amount due is (C a C e )erT > 0.

J. Robert Buchanan

Solutions and Proofs: American Options

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