Week 2: Instantaneous Risk-Less Profit –

Arbitrage
(see also P.Wilmott, Chapter 2)

Lecture II.1 Important Inequalities

The goal of the next two lectures is to show that financial derivatives satisfy some conditions,
which prevent a risk-less profit. The constraints will be used in further lectures for testing
analytically derived formulas for derivative values.

Pricing derivatives may seem like a very complicated task involving a lot of complex
calculations. This may be true for some financial products. But rather amazingly a lot of very
important information about derivatives can be obtained without any mathematical wizardry.
I think that discussion of these interesting relations for derivatives will be a nice warm up
before we shall turn to a bit more advanced topics of option pricing.

In all circumstances when the option price is not known precisely it is helpful to know at least
in which range of values it falls. In other words, it is important to know the maximal and
minimal possible values of the option price:

Minimal Value ≤ Option ≤ Maximal Value.

We start with some very simple observations of how various factors influence the derivative
price.

There are six main factors affecting the price of a share option1:
• The current share price
• The strike price
• The time to expiration
• The volatility of the share price
• The risk-free interest rate
• The dividends expected during the life of the option

Share Price And Strike Price

If it is exercised at some time in the future, the payoff from a call option will be the amount
by which the share price exceeds the strike price, S - E. Call options therefore become more
valuable as the share price increases and less valuable as the strike price increases. For a put
option, the payoff on exercise is the amount by which the strike price exceeds the share price,
E - S. Put options therefore behave in the opposite way to call options. They become less
valuable as the share price increases and more valuable as the strike price increases.

Time To Expiration

1
Options are known as share options in Britain and as stock options in America.
Both put and call American options 2 become more valuable as the time to expiration
increases. To see this, consider two options that differ only as far as the expiration date is
concerned. The owner of the long-life option has all the exercise opportunities open to the
owner of the short-life option – and more. The long-life option must therefore always be
worth at least as much as the short-life option.

Opportunities do not come up for free.

European put and call options also become more valuable as the time to expiration increases3.
However, this property is less clear compared with American options. This is because it is not
true that the owner of a long-life European option has all the exercise opportunities open to
the owner of a short-life European option. The owner of the long-life EO can exercise only at
the maturity of that option. Nevertheless it is clear that for longer periods of time, there are
always more chances that the share price moves favourably for any option. The exception are
so-called knock-out barrier options for which longer time periods lead to higher probabilities
of the option being knocked out.

Volatility

The volatility of a share price is a measure of how uncertain we are about future share price
movements. As volatility goes up, the chance that the share will do very well or very poorly
increases. For the owner of share, these two outcomes tend to offset each other. However,
this is not so for the owner of a call or put. The owner of a call benefits from price increases
but has limited downside risk in the event of price decreases since the most that he or she can
lose is the price of the option. Similarly, the owner of a put benefits from price decreases but
has limited upside risk in the event of price increases. The value of both calls and puts
therefore increase as volatility increases. In economies with zero volatility, options can not
exist. An example was the Soviet Union where all prices were fixed within the planned
economy. At present, maybe only Cuba has an “options-free” planned economy.

Again for knock-out barrier options, this property does not hold for all share prices. If the
spot price is close to the barrier, the rising volatility increases the probability of the option
being knocked out.

Risk-Free Interest Rate

The effect of the risk-free interest rate on the price of an option can be clarified in the
following way. When interest rates are higher, it is more profitable to keep money in bank
accounts instead of investing it into shares. Therefore, an American call option holder would
prefer to hold to the option instead of the share. This means that the American call option
becomes more valuable for the high risk-free interest rate.

An American put option holder would, of course, prefer at any opportunity to exercise the
option to get the cash. This means that the American put option will become less valuable

2
An American call or put option gives the holder the right to buy or sell one share for a certain price (E) at any
time before an expiration date.
3
When there are no dividends, ECO is equal to ACO and therefore has the properties of the AC, that is, a ECO
becomes more valuable as the time to expiry increases. This will be explained later on.
when the risk-free interest rate rises. In general, since an American option can be presented as
a combination of a large number of European options, the later mimic the behaviour of
American ones.

Of course, if there is a liquidity problem in the market, the damping of shares can cause their
prices to plummet which will negatively influence the price of calls but will increase the
value of puts. However, for the time being we will assume that the market is liquid.

At a slightly more technical level, as interest rates in the economy goes up, the expected
growth rate of the share price tends to increase. However, the present value of any future cash
flow received by the holder of the option decreases. These two effects both tend to decrease
the value of a put option (because of an overall dominance of the growth rate of the share
price, which will be increasing). Hence, put option prices decline as the risk-free interest rate
increases. In the case of calls, the first effect (the expected growth rate) tends to increase the
price while the second effect (the present value of a future cash flow) tends to decrease it. It
can be shown that the first effect always dominates the second effect (since the expected
growth rate is always higher than the risk-free rate due to the risk premium); that is, the prices
of calls always increase as the risk-free interest rate increases.

It should be emphasized that these results assume that, as we change the risk-free rate, all
other variables remain fixed, in particular, we assume that the share price to remain the same.
But in practice, when interest rate rise (fall), share prices tend to fall (rise) (as we can watch it
now for the US Dow Jones). The net effect of an interest rate change and the accompanying
share price change may be different from that just given. I hope it is not very confusing.

Dividends

Dividends have the effect of reducing the share price on the ex-dividend date. For example if
a share, S, pays dividend D, on the ex-dividend date it will cost S - D. This is bad news for
the value of call options and good news for the value of put options. The value of call options
are therefore negatively related to the sizes of any anticipated dividends, and the values of put
options are positively related to the size of any anticipated dividends.

Later on, when we will be deriving formulas for option prices, we will check our empirical
arguments with the mathematically obtained expressions.

Assumptions and Notations

So far we have considered how various factors affect the derivative price based on common
sense. Now I would like to derive some more specific relationships between option prices
that do not require any assumptions about volatility and the probabilistic behaviour of share
prices. In other words, we obtain some relationships that do not require any calculations.

All we assume is the following. There are some market participants, such as large investment
bank, for which

1. There are no transaction costs.

2. All trading profits (net of trading losses) are subject to the same tax rate.
3. Borrowing and lending at the risk-free interest rate is possible.
These assumptions are quite reasonable.
We will use the following notation:

S: current share price

E: strike price of option
T: time of expiration of option
t: current time
ST: share price at time T
r: risk-free rate of interest for maturity T (continuously compounded: see below)
C: value of American call option to buy one share
P: value of American put option to sell one share
c: value of European call option to buy one share
p: value of European put option to sell one share
σ: volatility of share price.

While all notations are self-explanatory, the continuously compounded interest rate has to be
further explained.

Continuous Compounding

Consider an amount A invested for n years at an interest rate of R per annum. If

the rate is compounded once per annum, the terminal value of the investment is
A(1 + R) n .

If it is compounded m times per annum, the terminal value of the investment is

m ⋅n
 R
A1 +  .
 m
Suppose that A=€100, R=10% per annum, and n=1, so that we are considering one year.
When we compound once per annum (m=1), this formula shows that the €100 grows to

€ 100 (1 + 0.1) = €110.

When we compound twice a year (m=2), the formula shows that the €100 grows to

2
 0.1 
€ 100 1 +  = € 110.25.
 2 

When we compound four times a year (m=4), the formula gives

4
 0.1 
€ 100 1 +  = €110.38.
 4 

The limit as m tends to infinity is known as continuous compounding. It can be shown4 that
an amount A invested for n years at rate R grows to

4
 Ae R⋅n ,

where e is the mathematical constant, 2.71828… For A=€100

€ 100e 0.1 ≈ €110.52.

This is (to two decimal places) the same as the value using daily compounding (m=365)

(
€ 100 1 + 0 .1 365 ) 365
≈ €110.52.

For most practical purposes continuous compounding can be thought of as being equivalent
to daily compounding.

Upper and Lower Bounds for Option Prices

Now we turn to derivation of the important relationships between options. These

relationships will be lower and upper bounds on option prices which will prevent
any risk-less profit. If any of the obtained restrictions is violated, one can make an
unlimited profit without taking any risk. The impossibility of such transactions constitutes the
key principle in deriving all mathematical relationships in the theory of option pricing -
arbitrage.

Arbitrage can be loosely stated as “there is no such thing as a free lunch”5. More formally, in
financial terms, there are never any opportunities to make an instantaneous risk-free profit.
(More correctly, such opportunities cannot exist for a significant length of time before prices
move to eliminate them.)

The key words in the definition of arbitrage are ‘instantaneous’ and ‘risk-free’; by investing
in equities, say, one can probably beat the bank, but this cannot be certain. If one wants a
greater return, then one must accept a greater risk.

Upper Bounds

An American or European call option gives the holder the right to buy one share of a stock
for a certain price (E). No matter what happens, the option can never be worth more than the
share. Hence, the share price is an upper bound to the option price:

c≤S and C ≤ S.

m ⋅n  R R 
 R m⋅n ln  1+  m⋅ n +... m →∞
A1 +  = Ae  m
= Ae m 
= Ae R ⋅n ,
 m
5
The funny thing is that at many banks they do have free lunches for their employees.
If these relationships are not true, say, at time t’<T, that is, c(t’)>S(t’), then an arbitrageur can
easily make a risk-less profit by buying the share (for S) and selling the call option (for c or
C) at time t’. The given transaction will give the risk-less profit at the exercise time

(c (t ' ) − S (t ' ))e r (T −t ') + E > 0.

Thus the upper bound must hold for all times.

An American or European put option gives the holder the right to sell one share of a stock for
E. No matter how low the share price becomes, the option can never be worth more than E.
Hence

p≤E and P ≤ E.
If these relationships are not true, an arbitrageur can make a risk-less profit. Indeed, in the
case of a European option, at the moment t’, when p(t’)>E, an arbitrager can write a put
which at the maturity time gives the following risk-less gain

p (t ' )er (T −t') − E + ST > 0 ,

since p (t ' )e r (T −t ') > p(t ' ). It follows that a European put must not be worth more than the
present value of E:

p ≤ Ee − r ( T −t ) .
If this were not true, an arbitrageur could make a risk-less profit by writing the option and
investing the proceeds of the sale at the risk-free interest rate.

In the case of an American put, at any time the upper bound must be P<E. Otherwise, for
example, by writing the option an arbitrager would be able to make a risk-less profit from
early exercise:

P(t ' ) − E + S (t ' ) > 0.

Lecture II.2 Put-Call Parity
In this lecture we will obtain lower bounds for vanilla options and also prove some useful
relationships between European and American options (on a non-dividend paying share).

Let us start with a prove of put-call parity for European options. Consider the following two
portfolios:

A: one European call option + an amount of cash equal to Ee − r ( T −t ) .

B: one European put + one share.

Both are worth

 max( ST , E )
at expiration of the options. Since the options are European, they cannot be exercised prior to
the expiration date. The portfolios must therefore have identical values today. This means
that
c + Ee− r (T −t ) = p + S . Equation 1

This relation is known as put-call parity. It shows that the value of a ECO with a certain
exercise price and exercise date can be deduced from the value of a EPO with the same
exercise price and date, and vice versa.

There is another way of deriving the put-call parity via valuation of a forward. Let us
consider a portfolio

C: One long call, c, and one short put, -p.

At expiration, the payoff is equal to ST - E irrespectively of the share price. This behaviour is
reminiscent of the properties of a forward contract f, if we identify the value of a long
forward contract, f, with c - p. For the forward contract f with delivery price E, we have6
f = S − Ee − r(T −t)
or
c − p = S − Ee − r( T −t ) .

This formula immediately gives rise to the equation for put-call parity.

Yet another way to derive put-call parity is to consider the following portfolio

D: one long asset, one long put and one short call. The call and the put, like in the
case of portfolio C, both have the same expiry date, T, and the same exercise price,
E. The payoff for this portfolio at expiry is

S + max( E − S ,0) − max( S − E ,0) = E .

Whether S is greater or less than E at expiry, the payoff is always the same, namely, E.

Now ask the question:
t=T? The answer is
portfolio is now worth
from a bank deposit. It
parity relationship:
How much would I pay for a portfolio that gives a guaranteed E at
obtained by discounting the final value of the portfolio. Thus, this
Ee − r (T −t ) . This equates the return from the portfolio with the return
is easy to see that this equation results in the above mentioned put-call

S + p − c = Ee− r (T −t ) .

If put-call parity does not hold, there are arbitrage opportunities.

6
Since the exercise price E is not necessarily equal to the delivery price F, f ≠ 0. However, in practice very
often, E is equal to F, i.e., p = c.
 Lower Bounds For c And p

Put-call parity is instrumental in deriving lower bounds for option prices. We can use formula
(1) to express c in terms of p:

c = p + S − Ee − r (T −t ) .
Since p>0 and c>0, we conclude that the following must be true

c > max( S − Ee− r( T −t ) ,0).

Similarly, we can write for p

p = c + Eer (T −t) − S .

Again, since both p and c are positive, we conclude that

p > max( Ee− r (T −t ) − S ,0).

Early Exercise: Calls

It is never optimal to exercise an American call option on a non-dividend-paying share early.

To present a formal argument, consider again the following two portfolios:

E: one American call + cash Ee −r (T −t ) .

F: one share.

The value of the cash in portfolio E at T is E (please, don’t confuse the name of ht e portfolio,
E, with the exercise price, E!). At some earlier time ô, it is Ee − r (T −τ ) . If the call option is
exercised at time ô, the value of portfolio E is

S − E + Ee −r (T −τ ) .

This is always less than S when ô<T, since r>0. Portfolio E is therefore always worth less
than portfolio F if the call is exercised prior to maturity. If the call option is held to
expiration, the value of portfolio E at time T is

max(S T , E ).

The value of portfolio F is ST. There is always some chance that S T<E. This means that
portfolio E is worth as much as, and sometimes worth more than, portfolio F.

We have shown that portfolio E is worth less than F if the option is exercised immediately,
but is worth at least as much as portfolio F if the holder of the option delays exercise until the
expiration date. It follows that a call option on a non-dividend-paying share should never be
exercised prior to the expiration date7. An American call option on a non-dividend-paying
share is therefore worth the same as the corresponding European call option on the same
share:

C = c.
For a quicker proof, we can use equation

c > S − Ee− r (T −t ) .
Since the owner of an American call has all the exercise opportunities open to the owner of
the corresponding European call, we must have

C ≥ c.
Hence
C ≥ S − Ee − r (T −t ) .

Since r>0, it follows from this that

C > S − E.
If it were optimal to exercise early, C would equal to S − E . However, it follows that C is
always greater, than S - E. Thus we have a contradiction based on the assumption that it is
optimal to exercise early. Thus, we deduce that it can never be optimal to exercise early.

One reason why a call option should not be exercised early can be considered as being due to
the insurance that it provides. When held instead of the share itself, a call option in effect
insures the holder against the share price falling below the exercise price. Once the option has
been exercised and the exercise price has been exchanged for the share price, this insurance
vanishes. Another reason is concerned with the time value of money. The later the strike
price is paid out the better.

Early Exercise: Puts

It can be advantageous to exercise an American put option on a non-dividend-paying share

early. Indeed, at any given time during its life, a put option should always be exercised early
if it is sufficiently deep in the money. To illustrate this, consider an extreme situation.
Suppose that the strike price is €10 and the sha re price is virtually zero. By exercising
immediately, an investor makes an immediate gain of €10. If the investor waits, the gain from
exercising might be less than €10 but it cannot be more than €10 since negative share prices
are impossible. And this is the main difference from the call, for which the share price can be
unlimited from above and, hence, the difference ST - E can be higher than any intermediate
S(t)-E. Furthermore, receiving €10 now is preferable to receiving €10 in the future. It follows
that the option should be exercised immediately.

It is instructive to consider the following two portfolios:

7
The price of portfolio E depends on strategy. If the strategy is to hold to the expiration date, the value of the
portfolio is maximal.
G: one American put option + one share.

H: an amount of cash equal to Ee− r (T −t ) .

If the option is exercised at time ô<T, portfolio G becomes worth E while portfolio H is worth
Ee− r( T −τ ) . Therefore
Gô > H ô.

That is, before expiration portfolio G is always greater than portfolio H. If the option is held
to expiration, portfolio G becomes worth

max( E , ST ),

while portfolio H is worth E. Therefore,

GT ≥ HT .

That is, at expiration portfolio G can become equal to portfolio H. This proves that the
amount of cash we get from early exercise is greater than that we would get, if we waited till
the expiration time. Thus, early exercise is desirable.

Like a call option, a put option can be viewed as providing insurance. A put option, when
held in conjunction with the share, insures the holder against the share price falling below a
certain level. However, a put option is different from a call option in that it may be optimal
for an investor to forgo this insurance and exercise early in order to realize the strike price
immediately. In general, the early exercise of a put option becomes more attractive as S
decreases, as r increases, and as ó decreases.

Lower Bound For An American Put

For an American put with price P, the lower bound is

P ≥ max(E − S ,0),

since immediate exercise is always possible. Normally, the share price grows as much as or
possibly more than the cash equivalent. Therefore, if the inequality does not hold, by
borrowing money the investor can make a risk-free profit: Buy a put, exercise it and get E - S,
collect the risk-less profit of (E - S) - P>0.
 P

E-S

A E Stock price S
Fig.1

Fig.1 shows the general way in which the price of an American put varies with S. Provided
that r>0, it is always optimal to exercise an American put immediately when the share price
is sufficiently low. When early exercise is optimal, the value of the option is E - S. The curve
representing the value of the put therefore merges into the put’s intrinsic value, E - S, for a
sufficiently small value of S.

Since there are some circumstances when it is desirable to exercise an American put option
early, it follows that an APO is always worth more than the corresponding EPO,
P > p.

Since an APO is sometimes worth its intrinsic value, it follows that a EPO must sometimes
be worth less than its intrinsic value.
 p

E-S

A B E Stock price S

Fig.2

Fig.2 shows the variation of the EPO with the share price. Note that point B in Fig.2, at which
the price of the option is equal to its intrinsic value, must represent a higher value of the share
price than point A in Fig.1. Point E in Fig.2 is where S=0 and the EPO is Ee − r (T −t ) .

Relationships Between C and P

Put-call parity holds only for European options. However, it is possible to derive some
relationships between American option prices for a non-dividend-paying share. Since P>p, it
follows that
P > c + Ee− r (T −t ) − S
and since c=C,
P > C + Ee −r (T −t) − S
or
C − P < S − Ee − r (T − t) . Equation 2

For a further relationship between C and P, consider

K: one ECO + cash E,

L: one APO + one share.

Both options have the same exercise price and expiration date. Assume that the cash in
portfolio K is invested at the risk-free rate. If the put option is not exercised early, portfolio L
is worth
max( ST , E )
at time T. Portfolio K is worth
 max( ST − E ,0) + Ee r( T −t ) = max(S T , E ) + Ee r(T −t ) − E

at this time. Since Ee r T −t − E > 0 , portfolio K is therefore worth more than portfolio L.
( )

Suppose next that the put option in portfolio K is exercised early, say, at time ô. Then
portfolio Lô is worth E. However, even if the call option were worthless, portfolio K would be
r (τ -t)
worth Ee at time ô. It follows that portfolio K is worth more than portfolio L in all
circumstances. Hence

c + E > P + S.
Since c = C,
C+E>P+S
or
C − P > S − E.
Combining this with Eq.2, we obtain

S − E < C − P < S − Ee − r( T −t ) .

Put-Call Parity In The Presence Of Dividends

If we use D to denote the present value of the dividend during the life of the option, then
when there are dividends, put-call parity becomes8

c + D + Ee− r (T −t ) = p + S .

Try To Answer The Following questions

1) What are the major factors affecting the price of a share option?
Explain how they affect the price.
2) Explain the principle of no arbitrage.
3) What are the lower and upper bounds for European and American option prices?
4) What is put-call parity? Does it hold for both European and American options?
5) Explain why an American call option on a non-dividend paying share should never be
exercised early, whereas early exercise of an American put is desirable?

8
When dividends are expected, we can no longer assert that an ACO will not be exercised early.