Chapter 9

Parity and Other Option Relationships

Put-Call Parity
For European options with the same strike price and time to expiration the parity relationship is
Call put = PV (forward price strike price) or
C ( K , T ) P ( K , T ) PV0,T ( F0,T K ) e rT ( F0,T K )

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9-2

Parity for Options on Stocks

Given the interest is continuously compounded, if underlying asset is a stock and PV0,T(Div) is the present value of the dividends payable over the life of the option, then PV( F0,T )= S0 PV0,T (Div), therefore: C(K,T) P(K,T) = S0 PV0,T(Div) PV0,T(K) C(K,T) P(K,T) = S0 PV0,T(Div + K) With:
S0 :Long stock PV0,T(Div + K): Long a zero-coupon Bond ( or lending )

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Parity for Options on Stocks

If underlying asset is an index, , therefore:

S0 PV0,T (Div) S0eT

C(K , T ) P(K , T ) S0e

PV0,T (K )

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9-4

Parity for Options on Stocks (contd)

Examples 9.1 & 9.2
Price of a non-dividend-paying stock: $40, r=8%, option strike price: $40, time to expiration: 3 months, European call: $2.78, European put: $1.99. $2.78=$1.99+$40 $40e -0.08x0.25 Additionally, if the stock pays $5 just before expiration, call: $0.74, and put: $4.85. $0.74-$4.85=($40 $5e-0.08x0.25) $40e-0.08x0.25

Synthetic security creation using parity

Synthetic stock: buy call, sell put, lend PV of strike and dividends Synthetic T-bill: buy stock, sell call, buy put Synthetic call: buy stock, buy put, borrow PV of strike and dividends Synthetic put: sell stock, buy call, lend PV of strike and dividends

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9-5

Properties of Option Prices

European versus American Options
Since an American option can be exercised at anytime, whereas a European option can only be exercised at expiration, an American option must always be at least as valuable as an otherwise identical European option CAmer(S, K, T) > CEur(S, K, T) PAmer(S, K, T) > PEur(S, K, T)

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9-6

Properties of Option Prices (contd)

Maximum and Minimum Option Prices
Call price cannot
be negative exceed stock price

S C Amer ( S , K , T ) CEur ( S , K , T ) max[0, PV0,T ( F0,T ) PV0,T ( K )]

Put price cannot
Be negative

be more than the strike price

K PAmer ( S , K , T ) PEur ( S , K , T ) max[0, PV0,T ( K ) PV0,T ( F0,T )]

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9-7

Option price
Option price = intrinsic value + time value

With call option: intrinsic value at any point in time is the difference between underlying stock price and strike price. With put option: intrinsic value at any point in time is the difference between strike price and underlying stock price. The longer the time to expiration, the higher the time value.
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Properties of Option Prices (contd)

Early exercise for American options
An American call option on a non-dividend-paying stock should not be exercised early, because

CAmer Ceur > ST -K

That means, one would lose money be exercising early instead of selling the option

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9-9

Properties of Option Prices (contd)

Time to Expiration
An American option (both put and call) with more time to expiration is at least as valuable as an American option with less time to expiration. A European call option on a non-dividend-paying stock will be more valuable than an otherwise identical option with less time to expiration.

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Properties of Option Prices (contd)

Different strike prices (K1 < K2 < K3), for both European and American options
A call with a low strike price is at least as valuable as an otherwise identical call with higher strike price C (K1 ) C (K 2 ) A put with a high strike price is at least as valuable as an otherwise identical put with low strike price

P(K 2 ) P(K1 )
The premium difference between otherwise identical calls with different strike prices cannot be greater than the difference in strike prices

C(K1 ) C(K2 ) K2 K1
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Properties of Option Prices (contd)

Different strike prices (K1 < K2 < K3), for both European and American options
The premium difference between otherwise identical puts with different strike prices cannot be greater than the difference in strike prices

P(K2) P(K1) K2 K1

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