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should be discounted more heavily than south-side vendor from whom you bor- the portfolio and the option are identi-
less risky payoff streams. rowed it. When all is said and done, you cal, it must be the case that the price of
have earned 10 cents without using any the option equals the value of the portfo-
It might seem as if calculating the value of your own wealth: This corresponds to lio; otherwise, an arbitrage opportunity
of the option should be fairly straightfor- an infinite rate of return! But why stop at would exist. A simple example might
ward. We know when the payoffs to the only 10 cents? If you borrowed 2 apples help explain their approach.
option will be received and what possible from the vendor, you could have made
values they may take. All we have to do 20 cents; if you borrowed 100 apples Suppose that today’s price for ABC stock
is to discount these expected future pay- you could have made $10. It appears that is $40. In one period from now the price
offs to determine the option’s value. you will be able to generate an indefinite of ABC stock will either rise to $60 or
amount of money by simply selling fall to $20. There is a European option on
But here’s the rub: What discount factor the ABC stock that has an expiration date
apples on the one side of the street and
do we use? A discount factor should in one period, with a strike price at $50.
buying them on the other.
reflect the underlying risk of the asset. The borrowing and lending interest rate
Since the option’s value is related to Unfortunately (for you), the forces of is 25 percent per period.
movements in the stock price of the ABC supply and demand will take hold and
company, it might seem reasonable to limit how much you can make. By This is all the information we require to
discount the option’s future expected attempting to sell large amounts of price the option. Note that the payoff to
payoffs with ABC’s discount factor. The apples on the north side, you will bid the the option in one period will be either
problem here is although the movement north-side price down, and by attempting $10 if the stock price rises or zero if it
in the option’s payoff perfectly tracks the to buy large amounts on the south side, falls. The Black-Scholes insight was to
stock price movements when they are you will bid the south-side price up. In construct a portfolio of existing assets
above $50, it does not at all track the the end, the price of apples on both sides that can replicate a payoff of $10 when
movement of the stock price when the of the street will be the same, and your the stock price goes up and zero when it
price is below $50. infinite-rate-of-return investment will goes down.
disappear.
This implies that the risk characteristics The portfolio in this example would
of the option are quite different from The apple parable helps explain why, for consist of 1/4 share of ABC stock and $4,
those of the underlying stock. And example, the U.S./Canadian dollar which has been borrowed. The value of
herein lies the obstacle that prevented exchange rate in the New York foreign- this portfolio today is $6—the stock is
generations of researchers from solving exchange market will be the same as in worth $10, and $4 must be repaid.
the option pricing formula: No appro- the Tokyo foreign-exchange markets. If
priate discount factor could be found. The payoff in one period matches that of
there was a discrepancy between these
the option: Your holdings of ABC stock,
rates, financial institutions would have
■ Arbitrage Basics if the price rises, will be worth 1/4 x $60,
an opportunity to make an infinite return
The big breakthrough came when two or $15. The $4 borrowed will be repaid
by selling the currency at the “over-
economists recognized that arbitrage with $5 since the interest rate is 25 per-
valued exchange” and buying currency
was the secret to unlocking the pricing cent, so the value of the entire portfolio
at the “undervalued exchange.” The
formula. The first step to grasping their will be $10. If the stock price falls, your
forces of supply and demand will ulti-
discovery is to understand the implica- holdings of ABC will be worth 1/4 x $20
mately equate the two exchange rates.
tions arbitrage has for the pricing of or $5. In this case, the portfolio’s value
anything in general. The key lesson here is that objects that are one period from now is zero: Your hold-
the same should trade at the same price; if ings of ABC stock just offset what you
To see these, consider a simple example. owe. In summary, the portfolio pays $10
they do not, then an arbitrage opportunity
Imagine that you visit a street, Main when the stock price is high, and zero
exists. Attempts to cash in on the opportu-
Street, which is lined with apple ven- when it is low.
nity will actually eliminate it and, in the
dors. On the south side of the street all
end, prices will be the same.
the vendors sell apples for 10 cents a Since the payoff to your portfolio is
piece, and on the north side they sell ■ Forget the Discount Factor, identical to the payoff of the option, it
them for 20 cents a piece. Whatever the stands to reason that the price of the
It’s All About Arbitrage
reason apples are trading at two differ- option should be $6, the value of your
Applying the lesson to options tells us
ent prices, it is possible for you to profit portfolio today. And it is an arbitrage
that if there are two options written on
from the apparent “mispricing.” argument that demonstrates that this
the same stock, with the same strike
must be so.
Suppose you go to the south side of the price and with the same expiration date,
street and ask a vendor if he would be then the prices of these two options must To see this, suppose that the option was
willing to “lend” you an apple, which be the same. But it does not tell us what selling at $7. Just as in the apple exam-
you would repay with an apple momen- that price should be. Or does it? ple, you can make an infinite rate of
tarily. You in turn sell the borrowed return by selling the “expensive good”
In 1973, economists Fisher Black and
apple on the opposite side of the street (the option) and buying the “cheap
Myron Scholes showed how the notion
for 20 cents. (If apples were stocks, good” (the portfolio). If you sell the
of arbitrage can be used to price an
what we have just described is “short- option, you will receive $7 but you will
option. Their big insight was that the
ing” a stock.) With 20 cents in hand you be required to pay $10 in one period
payoff structure of an option can be
run across the street, purchase an apple from now if the stock price turns out to
replicated by a portfolio of market-
for 10 cents, and return this apple to the be high. After selling an option, you can
traded assets. Since the cash payoffs to
FIGURE 1 STOCK PRICE TREE and down” many times. So the relevant portfolio is worth $28.60; hence, the
question is how to price an option when value of the option at date 1 when the
100 the price of the underlying asset can stock price is $60, denoted by node a in
move around many times before the figure 2, must be equal to $28.60. Simi-
80 expiration date. Black and Scholes real- larly, if the stock price is $20 at date 1,
ized that the arbitrage-portfolio replica- a portfolio consisting of .15 of ABC
tion argument described above needed stock will replicate the date-2 payoff of
60 60
to be used repeatedly. To illustrate, let’s the option. This portfolio costs $3;
continue with our simple example. hence, the value of the option at node b
in figure 2 is $3. The price of the option
40 Suppose that the option on the ABC at date 0 can be determined by working
40 stock, with strike price of $50, has an backward in the same fashion: It will be
expiration date three periods from now. given by the value of a portfolio that
20 20 Today, date 0, the price of ABC is $40; pays off $28.60 if the stock price
at each date the price can either increase increases to $60 at date 1 and $3 if the
0 0 or decrease $20. If, however, the stock stock price decreases to $20. A portfo-
price ever is zero, it remains at zero for- lio that consists of borrowing $7.84 and
date 0 date 1 date 2 date 3 ever. Figure 1, which is a “stock price buying .64 of ABC stock will give such
tree,” describes the set of possible stock payoffs, and it costs $17.76 to buy such
prices for ABC over the next three peri- a portfolio. Therefore, the value of the
ods. We will use it to calculate the price option at date 0 is $17.76.
of the option today, at date 0.
FIGURE 2 OPTION PRICE TREE Black and Scholes used the method of
Suppose that at date 2, the stock price is repeated, or “dynamic,” portfolio repli-
$40. In this situation, the option will cation, along with an arbitrage argu-
50 either pay $10 or $0 at date 3. From the ment, to determine the price of the
example above, we know that the price option. At each date, the value of the
40 of the option will be $6, and that a port- portfolio is precisely equal to what is
folio consisting of $4 borrowed and 1/4 needed to buy a new portfolio that can
stock of ABC can replicate the payoff of replicate the subsequent period’s pay-
a 10
the option. Similarly, if the stock price offs. In the end, the date-3 payoffs to
at date 2 is $80, then the option will pay the option can be replicated. If, in our
off either $50 ($100 – $50) or $10 example, the price of the option is not
($60 – $50), depending upon whether equal to $17.76, say it is $20, an infi-
6 the stock goes up or down at date 3. A nite rate of return can be made; you sell
portfolio consisting of borrowing $40 the option and buy the date-0 portfolio.
b 0 and buying one unit of ABC stock can The returns to the portfolio with
replicate the payoffs of the option. This dynamic replication will precisely pay
0 0 portfolio, and hence the option, has a off your option obligations, you pocket
value equal to $40. Finally, at date 2, if $2.24, and the desire to capture more of
date 0 date 1 date 2 date 3 the stock price is zero, the payoff to the this “free money” will imply that the
option will be zero at date 3, and a port- forces of supply and demand will
folio consisting of “nothing,” which equate the value of the replicating port-
costs nothing, is able to replicate the folio and the option.
purchase the portfolio described above option’s payoff.
for $6. That leaves you with $1 in your ■ Arbitrage and Economic
So, we have determined the price of the
pocket. The portfolio will pay off $10 Efficiency
option at date 2 for all possible out-
one period from now when the stock Arbitrageurs help make markets effi-
comes. By using the same kind of rea-
price is high, which is exactly what you cient. When, for some reason, prices
soning we will be able to determine the
need to pay off your option obligation. get out of line with one another, arbi-
price of the option at period 1 when the
Hence, you have made $1 for sure with- trage will get the prices back in line. As
stock price is $60 and when it is $20 and
out using any of your wealth. But you a result, prices will reflect the “true val-
finally at period 0.
will continue as long as the profit ues” of the traded objects. The notion
opportunity exists, and the forces of Figure 2, which is an “option price tree,” of arbitrage has improved the efficiency
supply and demand will ultimately describes the price of the option for the of markets in another, and perhaps,
equate the value of the portfolio with various realizations of the stock price. unexpected way. The ideas behind arbi-
the price of the option. At date 1, if the stock price is $60, then trage helped financial market partici-
a holder of the option is holding an asset pants price derivative assets, such as
So far, all this seems pretty simple, but that will be worth either $40 or $6 at options. These derivative assets can be
that is because the example is simple. In date 2, depending upon whether the used to manage risk and, when cor-
reality when someone purchases an price of the stock goes up or down at rectly priced, will enhance the effi-
option, the expiration date is many days date 2. A portfolio consisting of borrow- ciency of markets and firms and, as a
into the future and, as a result, the stock ing $22.40 and buying .85 of ABC stock result, society.
price has the opportunity to move “up can replicate these date-2 payoffs. This
Ed Nosal is a senior economic advisor at the
Federal Reserve Bank of Cleveland, and
Tan Wang is the Peter Lusztig Associate
professor of Finance at the University of
British Columbia.
PRSRT STD
Federal Reserve Bank of Cleveland U.S. Postage Paid
Research Department Cleveland, OH
P.O. Box 6387 Permit No. 385
Cleveland, OH 44101