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Effect of Variables On Option Pricing: C P C P S X T R D

- The document discusses the effect of various variables like stock price, strike price, time to maturity, volatility, and interest rate on the pricing of European call, put, and parity options. It provides bounds for call and put prices and discusses extensions of put-call parity for American options. - An example shows an arbitrage opportunity exists when a European call price violates the upper bound based on stock price, strike price, dividend, and time to maturity. Shorting stock and buying the underpriced call creates riskless profit. - A second example identifies an arbitrage in violated put-call parity through borrowing, shorting one option, and buying the other. Receiving the dividend eliminates the borrowing cost to create

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79 views9 pages

Effect of Variables On Option Pricing: C P C P S X T R D

- The document discusses the effect of various variables like stock price, strike price, time to maturity, volatility, and interest rate on the pricing of European call, put, and parity options. It provides bounds for call and put prices and discusses extensions of put-call parity for American options. - An example shows an arbitrage opportunity exists when a European call price violates the upper bound based on stock price, strike price, dividend, and time to maturity. Shorting stock and buying the underpriced call creates riskless profit. - A second example identifies an arbitrage in violated put-call parity through borrowing, shorting one option, and buying the other. Receiving the dividend eliminates the borrowing cost to create

Uploaded by

Patricia
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© © All Rights Reserved
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Effect of Variables on Option

Pricing
Variable
S0
X
T

r
D

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+
+

+?
+

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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

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