Put-Call Parity

Put-call parity is the relationship that must exist between the prices of
European put and call options that both have the same underlier, strike price
and expiration date. (Put-call parity does not apply to American options
because they can be exercised prior to expiry.) This relationship is illustrated
by arbitrage principles that show that certain combinations of options can
create positions that are the same as holding the stock itself. These option
and stock positions must all have the same return; otherwise, an arbitrage
opportunity would be available to traders.
A portfolio comprising a call option and an amount of cash equal to the
present value of the option's strike price has the same expiration value as a
portfolio comprising the corresponding put option and the underlier. For
European options, early exercise is not possible. If the expiration values of
the two portfolios are the same, their present values must also be the same.
This equivalence is put-call parity. If the two portfolios are going to have the
same value at expiration, they must have the same value today, otherwise
an investor could make an arbitrage profit by purchasing the less expensive
portfolio, selling the more expensive one and holding the long-short position
to expiration.
Any option pricing model that produces put and call prices that don't satisfy
put-call parity should be rejected as unsound because arbitrage opportunities
exist.
For a closer look at trades that are profitable when the value of corresponding
puts and calls diverge, refer to the following article: Put-Call Parity and
Arbitrage Opportunity.
There are several ways to express the put-call parity for European options.
One of the simplest formulas is as follows:
Formula 15.11
c + PV(x) = p + s
Where:
c = the current price or market value of the
European call
x = option strike price
PV(x) = the present value of the strike price
'xeuropean' discounted from the expiration
date at a suitable risk-free rate
p = the current price or market value of the
European put
s = the current market value of the
underlyer

The put-call parity formula shows the relationship between the price of a put
and the price of a call on the same underlying security with the same
expiration date, which prevents arbitrage opportunities. A protective put
(holding the stock and buying a put) will deliver the exact payoff as a
fiduciary call (buying one call and investing the present value (PV) of the
exercise price).
Note: There are much more
sophisticated formulas for analyzing
put-call relationships. For the exam,
you should know that a protective put
= fiduciary call (asset + put = call +
cash).

What is the 'Binomial Option Pricing Model'

The binomial option pricing model is an options valuation method developed
in 1979. The binomial option pricing model uses an iterative procedure,
allowing for the specification of nodes, or points in time, during the time span
between the valuation date and the option's expiration date. The model
reduces possibilities of price changes, and removes the possibility for
arbitrage. A simplified example of a binomial tree might look something like
this:

BREAKING DOWN 'Binomial Option Pricing Model'

The binomial option pricing model assumes a perfectly efficient market.
Under this assumption, it is able to provide a mathematical valuation of an
option at each point in the timeframe specified. The binomial model takes a
risk-neutral approach to valuation and assumes that underlying security
prices can only either increase or decrease with time until the option expires
worthless.

Binomial Pricing Example

A simplified example of a binomial tree has only one time step. Assume there
is a stock that is priced at $100 per share. In one month, the price of this
stock will go up by $10 or go down by $10, creating this situation:

Stock Price = $100

Stock Price (up state) = $110
Stock Price (down state) = $90
Next, assume there is a call option available on this stock that expires in one
month and has a strike price of $100. In the up state, this call option is worth
$10, and in the down state, it is worth $0. The binomial model can calculate
what the price of the call option should be today. For simplification purposes,
assume that an investor purchases one-half share of stock and writes, or
sells, one call option. The total investment today is the price of half a share
less the price of the option, and the possible payoffs at the end of the month
are:
Cost today = $50 - option price
Portfolio value (up state) = $55 - max ($110 - $100, 0) = $45
Portfolio value (down state) = $45 - max($90 - $100, 0) = $45
The portfolio payoff is equal no matter how the stock price moves. Given this
outcome, assuming no arbitrage opportunities, an investor should earn the
risk-free rate over the course of the month. The cost today must be equal to
the payoff discounted at the risk-free rate for one month. The equation to
solve is thus:
Option price = $50 - $45 x e ^ (-risk-free rate x T), where e is the
mathematical constant 2.7183
Assuming the risk-free rate is 3% per year, and T equals 0.0833 (one divided
by 12), then the price of the call option today is $5.11.
Due to its simple and iterative structure, the binomial option pricing model
presents certain unique advantages. For example, since it provides a stream
of valuations for a derivative for each node in a span of time, it is useful for
valuing derivatives such as American options. It is also much simpler than
other pricing models such as the Black-Scholes model.

Risk-Neutral Probabilities
We can use an arbitrage argument to set the right probability of an upward move (_) as a
function of the riskfree rate.
At any point, investors can either (a) hold $1 stock or (b) invest $1 at the risk-free rate r.
A risk-neutral investor would not care which portfolio they owned if they had the same
return.
Setting equal the returns from the stock (__+(1_)/_) and the risk-free portfolio (1+r), we
can solve for _ to determine the risk-neutral probability.

But in truth, investors are not risk-neutral. In order to take the riskier investment they must be
paid a premium.
Single-Step Option Pricing
Binomial trees price options using the idea of risk-neutral valuation.
Suppose a stock price is currently at $20, and will either be at $22 or $18 in three months.
What is the price of a European call option for a strike price of $21? Clearly, this reduces to
determining the probability of the upward price movement.
Risk Neutral Valuation
The risk-neutral investor argument for setting this probability can be applied if we set up two
portfolios which are of provably of equal risk and value.
We will construct two riskless portfolios, one involving the stock and the other the risk-free
rate.
Using Options to Eliminate Risk
A riskless portfolio can be created by buying _ shares of stock and selling a short position in
1 call option, such that the value of the portfolio is the same whether the stock moves up or
down.
If the stock moves to $22, our portfolio will be worth
$22_ $1 1, since we must pay the return of the option we sold.
If the stock moves to $18, our portfolio will be worth
$18_ $0, since the option we sold is worthless.
A riskless portfolio is constructed by buying _ = 0.25 shares, since it is the solution of
$22_ $1 1 = $18_.
Valuing the Portfolio
Whether the stock goes up or down, this portfolio is worth $4.50 at the end of the period.
The discounted value of this portfolio today, V , can be computed given the risk-free interest
rate r. Thus
V = (4.50)ert.
Since the value of V is equal to owning _ = 0.25 shares of stock at $20 per share minus the
value f of the option,
f = 20 0.25 V .
The General Case
In general, if there is an upward price movement, the value at the end of the option is S0u_
fu where S0u (fu) the price of the stock (option) after an upward movement.
If there is a downward price movement, the value at the end of the option is
S0d_ fd
Setting them equal and solving for _ yields
_=
fu fd
S0u S0d
The present value of the portfolio with a risk-free rate of r is
(S0u_ fu)erT which can be set up for a cost of S0_ f.
Equating these two and solving for f yields
f = S0_ (S0u_ fu)erT
By definition, the value of f must also be
f = erT (_fu + (1 _)fd) where _ is the probability of an upward movement.
Solving for _ we get
_=
erT du d
Interpreting this Probability
The expected stock price at time T implied by these probabilities is S0erT .

This implies that the stock price earns the risk free rate.
The value of an option is its expected payoff in a risk-neutral world discounted at the riskfree rate.
Irrelevance of Stocks Expected Return
When we value an option in terms of the price of the underlying asset, the probability of up
and down movements in the real world is irrelevant, since they can be hedged.
This is an example of a more general result stating that the expected return (drift) on the
underlying asset in the real world is irrelevant.
The option has to have the risk-neutral valuation, because if not there exists an arbitrage
opportunity buying the right portfolio.
Pricing Options with Binomial Trees
The value of the option can be worked backwards from the terminating (basis) condition level
by level.
The value of the option on leaf / terminating level is determined because the option price at
expiration is completely given by the stock and strike prices.
Finer Gradations
Adding additional levels to the trees allows finer price gradations than just a single up or
down.
The price of an option generally converges after about n = 30 levels or so.
Note that the number of options needed (_) changes at each node/level in the binomial tree.
Thus to maintain a riskless portfolio options must be bought and sold continuously, a process
known as delta hedging.
Generalizing the Model
This binomial tree model can be generalized to include the effects of (1) dividends, by
changing the magnitude of the moves in the levels corresponding to dividend periods, (2)
changing interest rates, by using the rate appropriate on a given yield curve.
It can also be generalized to allow more than two price movements from each node, say
increase, decrease, and unchanged.
Pricing American Options
American options permit execution at any intermediate time point.
It pays to exercise a non-dividend paying American put early if the underlying stock price is
sufficiently low (say 0) due to time-value of money.
In general, it pays to exercise now whenever the payoff from immediate execution exceeds
the value computed for the option at that point.
The options can be priced by using the higher of the two possible valuations at any point in
the tree.
American Put Example
Observe the difference between evaluating a put (S0 = 50,
strike price K = 52)) as European vs. American:
The price at each node is the maximum of SK ST and its European evaluation.
Early Exercise for American Calls
It can be proven that it never pays to execute an American call option early.
Consider a single period for an American call. Start at S0 and end at S0u or S0d, with
payoff fu and fd where 0 < fd <
erT < fu.
The no exercise condition erT (pfu + (1 p)fd) > S0 K clearly holds for K > S0.
The two other cases are:
S0d < K _ S0
K _ S0d

Options Pricing: Black-Scholes Model

The Black-Scholes model for calculating the premium of an option was
introduced in 1973 in a paper entitled, "The Pricing of Options and Corporate
Liabilities" published in the Journal of Political Economy. The formula,
developed by three economists Fischer Black, Myron Scholes and Robert
Merton is perhaps the world's most well-known options pricing model. Black
passed away two years before Scholes and Merton were awarded the 1997
Nobel Prize in Economics for their work in finding a new method to determine
the value of derivatives (the Nobel Prize is not given posthumously; however,
the Nobel committee acknowledged Black's role in the Black-Scholes model).
The Black-Scholes model is used to calculate the theoretical price of
European put and call options, ignoring any dividends paid during the
option's lifetime. While the original Black-Scholes model did not take into
consideration the effects of dividends paid during the life of the option, the
model can be adapted to account for dividends by determining the exdividend date value of the underlying stock.
The model makes certain assumptions, including:

The options are European and can only be exercised at expiration

No dividends are paid out during the life of the option

Efficient markets (i.e., market movements cannot be predicted)

No commissions

The risk-free rate and volatility of the underlying are known and
constant

Follows a lognormal distribution; that is, returns on the underlying are

normally distributed.

The formula, shown in Figure 4, takes the following variables into

consideration:

Current underlying price

Options strike price

Time until expiration, expressed as a percent of a year

Implied volatility

Risk-free interest rates

Figure 4: The Black-Scholes pricing

formula for call options.
The model is essentially divided into two parts: the first part, SN(d1),
multiplies the price by the change in the call premium in relation to a change
in the underlying price. This part of the formula shows the expected benefit
of purchasing the underlying outright. The second part, N(d2)Ke^(-rt),
provides the current value of paying the exercise price upon expiration
(remember, the Black-Scholes model applies to European options that are
exercisable only on expiration day). The value of the option is calculated by
taking the difference between the two parts, as shown in the equation.
The mathematics involved in the formula is complicated and can be
intimidating. Fortunately, however, traders and investors do not need to
know or even understand the math to apply Black-Scholes modeling in their
own strategies. As mentioned previously, options traders have access to a
variety of online options calculators and many of today's trading platforms
boast robust options analysis tools, including indicators and spreadsheets
that perform the calculations and output the options pricing values. An
example of an online Black-Scholes calculator is shown in Figure 5; the user
must input all five variables (strike price, stock price, time (days), volatility
and risk free interest rate).

Figure 5: An online Black-Scholes

calculator can be used to get values for
both calls and puts. Users must enter the
required fields and the calculator does
the rest. Calculator courtesy
The Black and Scholes Model:

The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black
started out working to create a valuation model for stock warrants. This work involved
calculating a derivative to measure how the discount rate of a warrant varies with time and
stock price. The result of this calculation held a striking resemblance to a well-known heat
transfer equation. Soon after this discovery, Myron Scholes joined Black and the result of
their work is a startlingly accurate option pricing model. Black and Scholes can't take all
credit for their work, in fact their model is actually an improved version of a previous model
developed by A. James Boness in his Ph.D. dissertation at the University of Chicago. Black
and Scholes' improvements on the Boness model come in the form of a proof that the riskfree interest rate is the correct discount factor, and with the absence of assumptions regarding
investor's risk preferences.

In order to understand the model itself, we divide it into two parts. The first part,
SN(d1), derives the expected benefit from acquiring a stock outright. This is
found by multiplying stock price [S] by the change in the call premium with
respect to a change in the underlying stock price [N(d1)]. The second part of the
model, Ke(-rt)N(d2), gives the present value of paying the exercise price on the
expiration day. The fair market value of the call option is then calculated by
taking the difference between these two parts.
Assumptions of the Black and Scholes Model:
1) The stock pays no dividends during the option's life
Most companies pay dividends to their share holders, so this might seem a
serious limitation to the model considering the observation that higher dividend
yields elicit lower call premiums. A common way of adjusting the model for this
situation is to subtract the discounted value of a future dividend from the stock
price.
2) European exercise terms are used
European exercise terms dictate that the option can only be exercised on the
expiration date. American exercise term allow the option to be exercised at any
time during the life of the option, making american options more valuable due to
their greater flexibility. This limitation is not a major concern because very few
calls are ever exercised before the last few days of their life. This is true because
when you exercise a call early, you forfeit the remaining time value on the call
and collect the intrinsic value. Towards the end of the life of a call, the remaining
time value is very small, but the intrinsic value is the same.

3) Markets are efficient

This assumption suggests that people cannot consistently predict the direction of
the market or an individual stock. The market operates continuously with share
prices following a continuous It process. To understand what a continuous It
process is, you must first know that a Markov process is "one where the
observation in time period t depends only on the preceding observation." An It
process is simply a Markov process in continuous time. If you were to draw a
continuous process you would do so without picking the pen up from the piece of
paper.
4) No commissions are charged
Usually market participants do have to pay a commission to buy or sell options.
Even floor traders pay some kind of fee, but it is usually very small. The fees that
Individual investor's pay is more substantial and can often distort the output of
the model.
5) Interest rates remain constant and known
The Black and Scholes model uses the risk-free rate to represent this constant
and known rate. In reality there is no such thing as the risk-free rate, but the
discount rate on U.S. Government Treasury Bills with 30 days left until maturity is
usually used to represent it. During periods of rapidly changing interest rates,
these 30 day rates are often subject to change, thereby violating one of the
assumptions of the model.
6) Returns are lognormally distributed
This assumption suggests, returns on the underlying stock are normally
distributed, which is reasonable for most assets that offer options.

Calculate Black Scholes Option Pricing Model Tutorial with

Definition, Formula, Example
Definition:
The Black-Scholes model is used to calculate the theoretical price of European put and call
options, ignoring any dividends paid during the option's lifetime.
Formula:

C = SN(d1)-Ke(-rt)N(d2)where,
C = Theoretical call premium S = Current stock price t = time K = option striking price r = risk free interest rate N = Cumulative standard normal
distribution e = exponential term (2.7183) d1 = ( ln(S/K) + (r + (s2/2))t ) / st d2 = d1 - st s = standard deviation of stock returns

Example :
A company currently sells for $210.59 per share. The annual stock price volatility is 14.04%,
and the annual continuously compounded risk-free interest rate is 0.2175%. Find the value of
d1 in the Black-Scholes formula for the price of a call on a company's stock with strike price
$205 and time for expiration of 4 days.

Given,
S= $210.59, K= $205 t = 4 days r = 0.2175% s = 14.04%

To Find,
Call option priced1

Solution :
Step 1:

Substitute the given value in the formula, d1 = ( ln(210.59/205) + (0.002175+(0.14042) / 2)

(0.01096) ) / 0.1404*(0.01096) d1 = 1.8394
Step 2:

d2 = 1.8394 - 0.1404*(0.01096) d2 = 1.8247

Step 3:

Substitute the value of d1 and d2 in the Call option (C) formula C = 210.59 * - 205 * SN(d1)Ke(-rt)N(d2) C = -8.1313