ECO 4378 Instructor: Saltuk Ozerturk 1.

Arbitrage when call price is below its lower bound We have established that the price of a call option with strike price X must satisfy: X c> S0 1+r } | {z
lower bound on call price

The following example illustrates that when the above relationship does not hold (i.e., when the call price is below its lower bound), then there is an arbitrage opportunity.

Example 1: Consider a call option on IBM stock with strike price X = $55 and which has 6 months until expiration. The current IBM stock price is S0 = $70 and the 6-month risk free rate of return is r = 10%. The price of this call option is c = 12. Let us rst illustrate that the call price is lower than its lower bound. To see this, note that the lower bound is given by Lower Bound = S0 X 55 = 70 = 20 1+r 1.10

whereas the call price is c = 12 and it is lower than the lower bound. Arbitrage position: Buy the call option at c = 12. Sell the stock short at S0 = $70. Invest the proceeds 70 12 = 58 at r = 10%. At the expiration date, the arbitrage trader must close the short stock position. In other words, he/she needs to buy one share of the stock. To prove that the above position always makes a prot, we need to consider two cases. If ST > 55 : In this case, the trader buys the stock through his/her call option. The payo to the arbitrage position is given by 58(1.10) + (ST 55) ST = $8.8 > 0 1

 If ST < 55 : In this case, the trader buys the stock directly in the market at ST . Call option is not exercised. The payo to the arbitrage position is given by 58(1.10) ST = 63.8 ST > 0 for ST < 55. Exercise 1: A European call option (on a stock) that expires in 6 months has a strike price of $88. The current stock price is $90 and the 6-month risk free interest rate is 10%. a) What is the lower bound for the price of that call? Identify the arbitrage strategy if the call price is c = 8. b) For the arbitrage strategy you described above, nd the arbitrage prot when at expiration the stock price turns out to be ST = 60. c) What is the arbitrage prot if ST = 90? 2. Arbitrage when put price is below its lower bound We have established that the price of a put option with strike price X must satisfy: X S0 p> 1+r | {z }
lower bound on put price

The following example illustrates that when the above relationship does not hold (i.e., when the put price is below its lower bound), then there is an arbitrage opportunity.

Example 2: Consider a put option on IBM stock with strike price X = $110 and which has 6 months until expiration. The current IBM stock price is S0 = $90 and the 6-month risk free rate of return is r = 10%. The price of this put option is p = 8. Let us rst illustrate that the put price is lower than its lower bound. To see this, note that the lower bound is given by Lower Bound on put price = X 110 S0 = 90 = 10 1+r 1.10

whereas the put price is p = 8 and it is below the lower bound. 2

 Arbitrage position: Buy the put option at p = 8. Buy the stock at S0 = $90. To nance this arbitrage portfolio position, borrow p + S0 = 8 + 90 = 98 at r = 10%. At the expiration date, the arbitrage trader must pay back the loan. To prove that the above position always makes a prot, we need to consider two cases. If ST < 110 : In this case, the trader sells the stock through his/her put option. The payo to the arbitrage position is given by (110 ST ) + ST 98(1.10) = 2.2 If ST > 110 : In this case, the trader sells the stock directly in the market at ST . Put option is not exercised. The payo to the arbitrage position is given by ST 98(1.10) > 0 for ST > 110. Exercise 2: A European put option (on a stock) that expires in 6 months has a strike price of $44. The current stock price is $33 and the 6-month risk free interest rate is 10%. a) What is the lower bound for the price of that put? Identify the arbitrage strategy if the put price is p = 5. b) For the arbitrage strategy you described above, nd the arbitrage prot when at expiration the stock price turns out to be ST = 50. c) What is the arbitrage prot if ST = 30? 3. Arbitrage when put-call parity does not hold We have established that the price of a put option with strike price X and the price of a call option with strike X (written on the same underlying asset) must satisfy: p + S0 = c + X 1+r

The following example illustrates that when the above relationship does not hold, then there is an arbitrage opportunity. 3

 Example 3: Consider a put option on IBM stock with strike price X = $110 and which has 6 months until expiration. The current IBM stock price is S0 = $90 and the 6-month risk free rate of return is r = 10%. The price of this put option is p = 8. The price of the call option on the IBM stock with strike price X = $110 and with the same expiration date is c=10. Let us rst illustrate that the put-call parity does not hold. To see this, note that p + S0 = 8 + 90 = 98 < c + 110 X = 10 + = 110 1+r 1.10

Payo to the above arbitrage position:

Arbitrage position: Buy the put option at p = 8. Buy the stock at S0 = $90. Sell the call option at c = 10. To nance this position, borrow p + S0 c = 8 + 90 10 = 88 at r = 10%. If ST < 110, payo is (the trader exercises the put option) (110 ST ) + ST 88(1.10) = 13.2 If ST > 110, payo is (the short call exercised) ST (ST 110) 88(1.10) = 13.2 In both cases, the trader ends up selling the stock at X = $110.

Exercise 3: Consider a European call option and a put option on a stock each with a strike price of X = $22. The price of call is c = $4 and the price of put is p = $3. The 6-month risk free rate of interest is r = 10%. The current stock price is S0 = $20. Identify the arbitrage strategy and nd out the arbitrage traders prot as a function of ST .