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Example
A share of IBM sells for 75. The call has an exercise price of 76. The value of the call seems to be zero. In fact, it is positive and in one example equal to 2.
t=0
S = 75
S = 70, call = 0
Value of call = .5 x 4 = 2
Example
A share of IBM sells for 75. The put has an exercise price of 76. The value of the put seems to be 1. In fact, it is more than 1 and in our example equal to 3.
t=0
S = 75
S = 70, put = 6
Value of put = .5 x 6 = 3
Put-call parity
S + P = X*exp(-r(T-t)) + C at any time t. s + p = X + c at expiration In the previous examples, interest was zero or T-t was negligible. Thus S + P=X+C 75+3=76+2 If not true, there is a money pump.
If S + P = Xe-r(T-t) + C + e S and P are overpriced. Sell short the stock. Sell the put. Buy the call. Buy the bond. For instance deposit Xe-r(T-t) in the bank. The remaining e is profit. The position is riskless because at expiration s + p = X + c. i.e.,
Measuring risk
Rate of return =
Pt 1 Pt divt 1 Rj Pt
Sample average
1926 11.62
1927 37.49
1928 43.61
1929 -8.42
Sample average
Population mean
The value to which the sample average tends in a very long time. Each sample average is an estimate, more or less accurate, of the population mean.
Abstraction of finance
Theory works for the expected values. In practice one uses sample means.
Deviations
Rate of return on common stocks 11.62 37.49 43.61 sample average 21.075 21.075 21.075 deviation -9.455 16.415 22.535 deviation squared 89.39703 269.4522 507.8262 sample variance 578.8768 standard deviation 24.05986
Explanation
Square deviations to measure both types of risk. Take square root of variance to get comparable units. Its still an estimate of true population risk.