Parity and Other Option Relationships

• Put-call parity
• Generalized parity and exchange options
• Comparing options with respect to
style, maturity and strike

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 IBM Option Quotes

IBM option prices, dollars per share, October 16, 2007. The
closing price of IBM on that day was $119.60.

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 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)
• Intuition
• Buying a call and selling a put with the strike equal
to the forward price (F0,T = K) creates a synthetic
forward contract and hence must have a zero price

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 Parity for Options on Stocks
• If underlying asset is a stock and Div is the dividend
stream, then e−rT F0,T = S0 − PV0,T (Div), therefore

C(K, T ) = P (K, T ) + [S0 − PV0,T (Div)] − e−rT (K)

• Rewriting above

S0 = C(K, T ) − P (K, T ) + PV0,T (Div) + e−rT (K)

• If
S0 − PV0,T (Div) = S0 e−δT
• Then

C(K, T ) = P (K, T ) + S0 e−δT − PV0,T (K)

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 Parity for Options on Stocks (cont’d)

• Examples
• 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−0.08×0.25

• Additionally, if the stock pays $5 just before

expiration, call: $0.74, and put: $4.85. ⇒

$0.74 = $4.85 + ($40 − $5e−0.08×0.25 ) − $40e−0.08×0.25

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 Parity for Options on Stocks (cont’d)

• 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
(conversion)
• 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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 Why net premium must be positive?
• The price of an ATM call must be higher than the price of
an ATM put
• Why? Long call and short put is an alternative to outright
purchase
Outright Purchase of a Stock
Day 0 Day 91
Own 1 share

–$40

Buy Call, Sell Put

Own 1 share

–$0.79 –$40
• The latter strategy allows us to defer to payment of $40
until expiration
• We must pay 3 months of interest on $40, whose PV is
$0.79
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 Options on currencies

• Recall currency forward pricing F0,T = x0 e(r−ry )T

• Also known as ‘interest rate parity’
• Suppose the option is to buy euro with $
• The parity becomes

C(K, T ) − P (K, T ) = x0 e−ry T − Ke−rT

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 Options on currencies
Suppose that you buy a e1,000,000 call option against dollars
with a strike price of $1.2750/e. Describe this option as the
right to sell a specific amount of dollars for euros at a
particular exchange rate of euros per dollar. Why is this latter
option a dollar put option against the euro?

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 Options on currencies

The dollar-denominated euro call and the euro-denominated

dollar put differ in two aspects:
1 The scale of the two options is different

2 The currency of denomination is different (exchange rate

is the price of one currency in terms of another)

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 Generalized Parity Relationship
Suppose we have an option to exchange one asset for
another. Asset A is underlying asset, with price St . B is strike
asset (in exchange for the underlying asset) with price Qt .
There is no arbitrage opportunity if
P P
C(St , Qt , T − t) − P (St , Qt , T − t) = Ft,T (S) − Ft,T (Q)
Expiration
Transaction Time 0 ST ≤ QT ST ≥ QT
Buy call −C(St , Qt , T − t) 0 ST − QT
Sell put P (St , Qt , T − t) ST − QT 0
Sell prepaid
P
Forward on A Ft,T (S) −ST −ST
Buy prepaid
P
Forward on B −Ft,T (Q) QT QT
−C(St , Qt , T − t)
+P (St , Qt , T − t)
P P
Total +Ft,T (S) − Ft,T (Q) 0 0
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 Currency Options
• current exchange rate x0 = 0.90$/e
• dollar-denominated euro call option with a strike of
K = $0.92/e, price C$ (x0 , K, T ) = $0.0337
• euro-denominated dollar put option with a strike of
e1
K
1
= $0.92 , price Pf ( x10 , K1 , T ) = e0.0407
Year 0 Year 1
Transaction x1 < 0.92 x1 ≥ 0.92
$ e $ e $ e
1 1
I: buyK euro calls −0.0366 0 0 −1 0.92
II. Convert $ to e −0.0366 0.0407
(divide by x0 )
1
buy $ put −0.0407 0 0 −1 0.92
The prices are related by
1 1 1 1
C$ (x0 , K, T ) = Pf ( , , T )
K x0 x0 K
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 Properties of Option Prices

American versus European

• 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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 Properties of Option Prices (cont’d)
Option price boundaries
• Call price cannot
• be negative
• exceed stock price
• be less than price implied by put-call parity using zero
for put price:
S > CAmer (S, K, T ) ≥ CEur (S, K, T ) ≥ max[0, PV0,T (F0,T ) − PV0,T (K)]

• Put price cannot

• be more than the strike price
• be less than price implied by put-call parity using zero
for call price:
K > PAmer (S, K, T ) ≥ PEur (S, K, T ) ≥ max[0, PV0,T (K) − PV0,T (F0,T )]

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 Properties of Option Prices (cont’d)
• Early exercise of American options
• A non-dividend paying American call option should
not be exercised early, because
CAmer ≥ CEur > St − K.
• this has to be true.
• For European option,
C = St − K + P + K − PV(K)
• That means, one would lose money be exercising
early instead of selling the option
• If there are dividends, it may be optimal to exercise
early
• Imagine a large dividend to come before expiration
• It may be optimal to exercise a non-dividend paying
put option early if the underlying stock price is
sufficiently low
• Imagine the stock price goes down to zero
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 Properties of Option Prices (cont’d)

• 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. This is
because the longer option can easily be converted
into the shorter option by exercising it early
• A European call option on a non-dividend paying
stock will be more valuable than an otherwise
identical option with less time to expiration.
• European call options on dividend-paying stock and
European puts may be less valuable than an
otherwise identical option with less time to expiration

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 Properties of Option Prices (cont’d)

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(K2 )
• A put with a high strike price is at least as valuable as an
otherwise identical call with low strike price
P (K2 ) ≥ P (K1 )
• Profit from purchasing a 50-strike call for $9 and selling a
55-strike call for $10. This is an arbitrage.

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Properties of Option Prices (cont’d)

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 Properties of Option Prices (cont’d)

Different strike prices (K1 < K2 < K3 ), for both European

and American options
• 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
• 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
• Profit from selling a 50- strike call for $18 and buying a
55-strike call for $12. This is an arbitrage.

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Properties of Option Prices (cont’d)

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 Properties of Option Prices (cont’d)

• Different strike prices (K1 < K2 < K3 ), for both

European and American options
• Premiums decline at a decreasing rate for calls with
progressively higher strike prices. (Convexity of
option price with respect to strike price)
C(K1 ) − C(K2 ) C(K2 ) − C(K3 )
≥
K2 − K 1 K3 − K 2
P (K2 ) − P (K1 ) P (K3 ) − P (K2 )
≤
K2 − K1 K3 − K2
• Profit from purchasing a 50-strike put for $4, selling
two 55-strike puts for $8, and buying a $60-strike put
for $11. This is an arbitrage.

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Properties of Option Prices (cont’d)

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 Summary of Parity Relationships

Versions of put-call parity. Notation in the table includes the

spot currency exchange rate, x0 ; the risk-free interest rate in
the foreign currency, ry ; and the current bond price, B0 .

Underlying Asset Parity Relationship

Futures Contract e−rT F0,T = C(K, T ) − P (K, t) + e−rT K

Stock, no S0 = C(K, T ) − P (K, t) + e−rT K
dividend
Stock, discrete S0 − PV0,T (Div) = C(K, T ) − P (K, t) + e−rT K
dividend
Stock, continuous e−rT S0 = C(K, T ) − P (K, t) + e−rT K
dividend
Currency e−ry T x0 = C(K, T ) − P (K, t) + e−rT K
Bond B0 − PV0,T (Coupons) = C(K, T ) − P (K, t) + e−rT K

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