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Put-call parity is the relationship that must exist between the prices of
European put and call options that both have the same underlier, strike price
and expiration date. (Put-call parity does not apply to American options
because they can be exercised prior to expiry.) This relationship is illustrated
by arbitrage principles that show that certain combinations of options can
create positions that are the same as holding the stock itself. These option
and stock positions must all have the same return; otherwise, an arbitrage
opportunity would be available to traders.
A portfolio comprising a call option and an amount of cash equal to the
present value of the option's strike price has the same expiration value as a
portfolio comprising the corresponding put option and the underlier. For
European options, early exercise is not possible. If the expiration values of
the two portfolios are the same, their present values must also be the same.
This equivalence is put-call parity. If the two portfolios are going to have the
same value at expiration, they must have the same value today, otherwise
an investor could make an arbitrage profit by purchasing the less expensive
portfolio, selling the more expensive one and holding the long-short position
to expiration.
Any option pricing model that produces put and call prices that don't satisfy
put-call parity should be rejected as unsound because arbitrage opportunities
exist.
For a closer look at trades that are profitable when the value of corresponding
puts and calls diverge, refer to the following article: Put-Call Parity and
Arbitrage Opportunity.
There are several ways to express the put-call parity for European options.
One of the simplest formulas is as follows:
Formula 15.11
c + PV(x) = p + s
Where:
c = the current price or market value of the
European call
x = option strike price
PV(x) = the present value of the strike price
'xeuropean' discounted from the expiration
date at a suitable risk-free rate
p = the current price or market value of the
European put
s = the current market value of the
underlyer
The put-call parity formula shows the relationship between the price of a put
and the price of a call on the same underlying security with the same
expiration date, which prevents arbitrage opportunities. A protective put
(holding the stock and buying a put) will deliver the exact payoff as a
fiduciary call (buying one call and investing the present value (PV) of the
exercise price).
Note: There are much more
sophisticated formulas for analyzing
put-call relationships. For the exam,
you should know that a protective put
= fiduciary call (asset + put = call +
cash).
Risk-Neutral Probabilities
We can use an arbitrage argument to set the right probability of an upward move (_) as a
function of the riskfree rate.
At any point, investors can either (a) hold $1 stock or (b) invest $1 at the risk-free rate r.
A risk-neutral investor would not care which portfolio they owned if they had the same
return.
Setting equal the returns from the stock (__+(1_)/_) and the risk-free portfolio (1+r), we
can solve for _ to determine the risk-neutral probability.
But in truth, investors are not risk-neutral. In order to take the riskier investment they must be
paid a premium.
Single-Step Option Pricing
Binomial trees price options using the idea of risk-neutral valuation.
Suppose a stock price is currently at $20, and will either be at $22 or $18 in three months.
What is the price of a European call option for a strike price of $21? Clearly, this reduces to
determining the probability of the upward price movement.
Risk Neutral Valuation
The risk-neutral investor argument for setting this probability can be applied if we set up two
portfolios which are of provably of equal risk and value.
We will construct two riskless portfolios, one involving the stock and the other the risk-free
rate.
Using Options to Eliminate Risk
A riskless portfolio can be created by buying _ shares of stock and selling a short position in
1 call option, such that the value of the portfolio is the same whether the stock moves up or
down.
If the stock moves to $22, our portfolio will be worth
$22_ $1 1, since we must pay the return of the option we sold.
If the stock moves to $18, our portfolio will be worth
$18_ $0, since the option we sold is worthless.
A riskless portfolio is constructed by buying _ = 0.25 shares, since it is the solution of
$22_ $1 1 = $18_.
Valuing the Portfolio
Whether the stock goes up or down, this portfolio is worth $4.50 at the end of the period.
The discounted value of this portfolio today, V , can be computed given the risk-free interest
rate r. Thus
V = (4.50)ert.
Since the value of V is equal to owning _ = 0.25 shares of stock at $20 per share minus the
value f of the option,
f = 20 0.25 V .
The General Case
In general, if there is an upward price movement, the value at the end of the option is S0u_
fu where S0u (fu) the price of the stock (option) after an upward movement.
If there is a downward price movement, the value at the end of the option is
S0d_ fd
Setting them equal and solving for _ yields
_=
fu fd
S0u S0d
The present value of the portfolio with a risk-free rate of r is
(S0u_ fu)erT which can be set up for a cost of S0_ f.
Equating these two and solving for f yields
f = S0_ (S0u_ fu)erT
By definition, the value of f must also be
f = erT (_fu + (1 _)fd) where _ is the probability of an upward movement.
Solving for _ we get
_=
erT du d
Interpreting this Probability
The expected stock price at time T implied by these probabilities is S0erT .
This implies that the stock price earns the risk free rate.
The value of an option is its expected payoff in a risk-neutral world discounted at the riskfree rate.
Irrelevance of Stocks Expected Return
When we value an option in terms of the price of the underlying asset, the probability of up
and down movements in the real world is irrelevant, since they can be hedged.
This is an example of a more general result stating that the expected return (drift) on the
underlying asset in the real world is irrelevant.
The option has to have the risk-neutral valuation, because if not there exists an arbitrage
opportunity buying the right portfolio.
Pricing Options with Binomial Trees
The value of the option can be worked backwards from the terminating (basis) condition level
by level.
The value of the option on leaf / terminating level is determined because the option price at
expiration is completely given by the stock and strike prices.
Finer Gradations
Adding additional levels to the trees allows finer price gradations than just a single up or
down.
The price of an option generally converges after about n = 30 levels or so.
Note that the number of options needed (_) changes at each node/level in the binomial tree.
Thus to maintain a riskless portfolio options must be bought and sold continuously, a process
known as delta hedging.
Generalizing the Model
This binomial tree model can be generalized to include the effects of (1) dividends, by
changing the magnitude of the moves in the levels corresponding to dividend periods, (2)
changing interest rates, by using the rate appropriate on a given yield curve.
It can also be generalized to allow more than two price movements from each node, say
increase, decrease, and unchanged.
Pricing American Options
American options permit execution at any intermediate time point.
It pays to exercise a non-dividend paying American put early if the underlying stock price is
sufficiently low (say 0) due to time-value of money.
In general, it pays to exercise now whenever the payoff from immediate execution exceeds
the value computed for the option at that point.
The options can be priced by using the higher of the two possible valuations at any point in
the tree.
American Put Example
Observe the difference between evaluating a put (S0 = 50,
strike price K = 52)) as European vs. American:
The price at each node is the maximum of SK ST and its European evaluation.
Early Exercise for American Calls
It can be proven that it never pays to execute an American call option early.
Consider a single period for an American call. Start at S0 and end at S0u or S0d, with
payoff fu and fd where 0 < fd <
erT < fu.
The no exercise condition erT (pfu + (1 p)fd) > S0 K clearly holds for K > S0.
The two other cases are:
S0d < K _ S0
K _ S0d
No commissions
The risk-free rate and volatility of the underlying are known and
constant
Implied volatility
The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black
started out working to create a valuation model for stock warrants. This work involved
calculating a derivative to measure how the discount rate of a warrant varies with time and
stock price. The result of this calculation held a striking resemblance to a well-known heat
transfer equation. Soon after this discovery, Myron Scholes joined Black and the result of
their work is a startlingly accurate option pricing model. Black and Scholes can't take all
credit for their work, in fact their model is actually an improved version of a previous model
developed by A. James Boness in his Ph.D. dissertation at the University of Chicago. Black
and Scholes' improvements on the Boness model come in the form of a proof that the riskfree interest rate is the correct discount factor, and with the absence of assumptions regarding
investor's risk preferences.
In order to understand the model itself, we divide it into two parts. The first part,
SN(d1), derives the expected benefit from acquiring a stock outright. This is
found by multiplying stock price [S] by the change in the call premium with
respect to a change in the underlying stock price [N(d1)]. The second part of the
model, Ke(-rt)N(d2), gives the present value of paying the exercise price on the
expiration day. The fair market value of the call option is then calculated by
taking the difference between these two parts.
Assumptions of the Black and Scholes Model:
1) The stock pays no dividends during the option's life
Most companies pay dividends to their share holders, so this might seem a
serious limitation to the model considering the observation that higher dividend
yields elicit lower call premiums. A common way of adjusting the model for this
situation is to subtract the discounted value of a future dividend from the stock
price.
2) European exercise terms are used
European exercise terms dictate that the option can only be exercised on the
expiration date. American exercise term allow the option to be exercised at any
time during the life of the option, making american options more valuable due to
their greater flexibility. This limitation is not a major concern because very few
calls are ever exercised before the last few days of their life. This is true because
when you exercise a call early, you forfeit the remaining time value on the call
and collect the intrinsic value. Towards the end of the life of a call, the remaining
time value is very small, but the intrinsic value is the same.
C = SN(d1)-Ke(-rt)N(d2)where,
C = Theoretical call premium S = Current stock price t = time K = option striking price r = risk free interest rate N = Cumulative standard normal
distribution e = exponential term (2.7183) d1 = ( ln(S/K) + (r + (s2/2))t ) / st d2 = d1 - st s = standard deviation of stock returns
Example :
A company currently sells for $210.59 per share. The annual stock price volatility is 14.04%,
and the annual continuously compounded risk-free interest rate is 0.2175%. Find the value of
d1 in the Black-Scholes formula for the price of a call on a company's stock with strike price
$205 and time for expiration of 4 days.
Given,
S= $210.59, K= $205 t = 4 days r = 0.2175% s = 14.04%
To Find,
Call option priced1
Solution :
Step 1:
Step 3:
Substitute the value of d1 and d2 in the Call option (C) formula C = 210.59 * - 205 * SN(d1)Ke(-rt)N(d2) C = -8.1313