3 - No Arbitrage Bound On Option

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
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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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

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?

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 )

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?

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?

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?

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?

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?

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

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).

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.

Payoffs
Payoff
K S(T)

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

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

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.

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 ).

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

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

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?

3 - No Arbitrage Bound On Option

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Lecture 3:

No-Arbitrage Bounds on Options

Deriving pricing formulas for options is more difficult

II. “Intuitive” Relations

III. No-Arbitrage Bounds

IV. Put-Call Parity

Bus 35100 Page 2 Robert Novy-Marx

II. Intuitive Relations

How does the price of an option change when we

Euro. Euro. Amer. Amer.

Bus 35100 Page 3 Robert Novy-Marx

III. No-Arbitrage Bounds

A. All Stock Options

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

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

Bus 35100 Page 4 Robert Novy-Marx

3. Options never have negative value (why?)

4. A European put option is never worth more than

5. American options are at least as valuable as

Bus 35100 Page 5 Robert Novy-Marx

6. American options with more time to maturity are

7. An American options as at least as valuable as

Bounds 6 and 7 don’t always hold for European

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B. Options on Non Dividend Paying Stocks

1. The price of a call option satisfies:

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

 European call options are always worth more

The second inequality holds because C  c.

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 What if c < S KB?

Transaction Payoff at t Payoff at T

 What if c > S KB?

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2. The price of a European put option satisfies:

European put options are always worth more

How does the inequality compare with 7?

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

What would the shaded region for an American

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

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

What would the shaded region for an American put

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C. Options on Dividend Paying Stocks

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IV. Put-Call Parity

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

 This rule is called put-call parity.

Intuition: The two portfolios

have exactly the same future payoffs. They must,

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Arbitrage Example: Suppose that:

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Which is worth more, an ATM call or put?

First, for what K should cK D pK ?

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

Bus 35100 Page 16 Robert Novy-Marx

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

European call options are always worth more

The second inequality holds because C c.

What if c < S KB?

What if c > S KB?

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

This rule is called put-call parity.

Calls are worth more at lower strikes

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

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