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Arbitrage bounds on Option Prices

Assumptions
No transaction costs

All transactions occur at single price (i.e. no bid

ask spread) No taxes No margin or short sale restrictions Trade can occur in stock and option markets instantaneously Dividends are received on the ex-dividend day, and ex-day stock price decline equals the dividend amount We restrict our discussion to stock options and index options. Some of these results do not apply

Pricing Restriction for Call (Upper bound)


Proposition 1: C < = S (i.e. highest amount a call can sell

for is the current value of the underlying asset) What if C > S (i.e. C S > 0) ? In such cases there would be arbitrage opportunities: K= Actual Price St= Strike price _______Today Before Expiry At Expiration___ (on exercise) ST > K ST <K __________________(American)____________________ ___ Sell Call + C Deliver stock - (ST K) 0 Buy Stock - S0 & receive K + ST + ST ______________________________________________ __

Pricing Restriction for Call (Lower bound)


Proposition II: C > = max [ S0 K e

0 ] European & American option on a non-dividend paying stock. The proposition implies that
If S0 < K e

rT,

then C must sell for more than zero. This is because that the worst that can happen is that it expires worthless, it cannot be negative. If S0 > K e rT, then C must sell for more than S0 - K e rT
What if C < [ S0 K e

rT,

0] (i.e. C + [ S0 K e rT, 0 ] > 0) ?

rT,

Pricing Restriction for Call (Lower bound)


Consider the following two portfolios: Portfolio A: 1 European call option + cash equal to K e Portfolio B: 1 share
rT

_______Today Expiration___

At

ST > K

ST

<K ______________________________________________ ___ Buy Call -C + (ST K) 0 Lend - K e rT +K +K Sell Stock + S0 - ST - ST

Some important insights


In the money call options on non dividend paying

stocks will always have some time value (except on the expiration day) An American call will never be exercised early
An investor receives a profit of S K (or intrinsic

value) on exercising the call option early if it is inthe-money However, on selling the call option, he will realize at least S0 K e rT , which is greater than intrinsic value Moreover, the call option provides the holder insurance which will vanish if he exercises the call option

Pricing Restriction for Put (Upper bound)


Proposition III: P < = K (i.e. highest amount a put can

sell for is the strike price) What if P > K (i.e. P K > 0) ? In such cases there would be arbitrage opportunities: _______Today Before Expiry At Expiration___ (on exercise) ST > K ST <K __________________(American)____________________ ___ Sell Put + P Receive stock 0 - (K - ST) Lend -K & deliver K + K + Int + K + Int ______________________________________________

Pricing Restriction for Put (Lower bound)


Proposition IV: P > = max [ K e
rT

&

- S0 ,0 ] European

P > = max [ K- S0 , 0 ] American option on a non-dividend paying stock. The proposition implies that
If S0 > K e

then P must sell for more than zero. This is because that the worst that can happen is that it expires worthless, it cannot be negative. If S0 < K e rT, then P must sell for less than S0 - K e rT since at expiry the payoff is going to be K e rT ST & thus P will trade lower than intrinsic value prior to expiry and move to K e rT ST at expiry If S0 < K, then American puts must sell for an amount greater than or equal to its ontrinsic value, K - S
What if P < [K e
rT-

rT,

S0 , 0 ]

Pricing Restriction for Call (Lower bound)


Consider the following two portfolios: Portfolio C: 1 European put option +1 share Portfolio D: amount of cash equal to K e
rT

_______Today Expiration___

At

ST > K

ST

<K ______________________________________________ ___ Buy Put -P 0 + (K - ST ) Borrow + K e rT -K K Buy Stock -S +S +S

Some more Insights


An American Put on a non-dividend-paying stock

can never sell below its intrinsic value


It will always have zero or positive time value American Puts can never sell for less than their

intrinsic value and can never rise in value as expiration date nears
A European Put on a non-dividend-paying stock

can sell for less tan its intrinsic value


ITM European puts will frequently sell for less than

intrinsic value and will rise in value as time passes

Put-Call Parity
Consider the following two pportfolio:
Portfolio A: 1 European call option + cash equal to

K e rT Portfolio C: 1 European put option +1 share


Both the portfolios are worth max (ST , K)
Since European options cannot be exercised

early, both the portfolios must have equal values today: c + K e rT = p + S0 If the above equation does not hold then arbitrage