DERIVATIVES & RISK MANAGEMENT

Name: Mohmedfaizal Kadri No.: 302422 Assignment: 01 (Put call parity) 24th July, 2013 Roll Date:

INTRODUCTION :
This assignment is about a conceptual understanding of the Put call parity. It refers to the relationship between call and put options for a provided stocks, strike price and date of expiry. Under put-call parity, the option prices should match, yielding no profit no loss or say e uilibrium. Put call parity is an attractive, noticeable opportunity arising from the options markets. !y clear understanding of put call parity, one can begin to better understand the procedure that professional investors may use to value options, how demand and supply impacts option prices and how all option values "at all the strike prices available and expiry date# related on the same underlying security.

UNDERSTANDING THE PUT-CALL PARITY :

To understand how the put call parity can be work, we should first know these points. $# Put call parity applicable only when one or % both are & a. 'uropean (ption. b. !oth portfolios expire on the same day and, c. !oth have same strike price. )# *orkout the argument consider two Portfolio + and !.

,# Portfolio + consists of an 'uropean call option and cash e ual to the number of shares covered by the call option multiplied by the strike price. Portfolio ! consist of an 'uropean put option and the underlying asset.

-# .or St > k & P"+# / 0t 1 'xercise the call option by paying money k by share "0t#2 and P"!# / 0t 1 3o not exercise the put option share is at value 0t2 Therefore, P"+# / P"!# 4# .or St

<k&
rT

Inserting the 5alue of portfolio C + Ke K = (P + So C) e

rT

= P + So and therefore

The equation suggests that knowing the price of one option the price of the other option calculated because K and So are known. +.

k < (P + So C) e rT :
a# *rite a Put option "6p# b# 0ell a share short "60o# c# !uy a 7all "-7# If St > k = o not e!ercise the Put option. If St < k = we will e!ercise the Put option and do not e!ercise the call option. "e will recei#e (P + So C) $e from the bank. Put option will exercised. %herefore bu& the share b& pa&ing a'ount K. 0ettle the short with a share purchased in 0tep ). Profit / "P + So C) $e - %
r% r%

!.

k > (P + So C) e rT :
a# !orrow " P 6 0o + C) b# (u& a Put option c# !uy a share d# *rite a call. If St If St

> k = "e will sell a share and recei#e K.

< k = %hen again K (P + So C) $e r% r% Therefore, % must be / (P + So C) $e

Note : )eferring the P(*) = P(()+ therefore K = (P + So C) $e for % 8 (P + So C) $e situation will prevail. Under this circumstances .ollowing steps will take &
r% r%

arbitrage

0ituation + &
0t 8 k, Put option 9apse, 7all option exercised. 0o give share and get %. (ut of % return "P + So C) $e
r% r%

Therefore Profit / % - (P + So C) $e

0ituation ! &
7onsider 0t : k, Put option will exercised. 3eliver the share which we have already purchased.

UPPER BOUND & LOWER BOUND :

1)

Uppe Bo!"# :

+n 'uropean call option gives a right to the buyer to purchase a share at a certain price. The call option cannot be more than the stock price.

c S0

)#

Lo$e Bo!"# :
The lower bound in the 'uropean put options will be &

p KerT S0

PROBLE% :

0tock price / ;s. <=, 0trike price for both put and call option ;s. 44, Time to expiry is ,= days. Price of the put option ;s. $).<=. Price for call option ;s. $,.>=. .rom the given information determine if an arbitrage situation exist ? If yes, explain what you would do to get risk free return.

7alculation &

7 6 K$er% / "p60o# $,.> @ 44 @ e A "=.$ @ ,=B,C4 # / "$).< 6 <=# $,.> @ 44 @ e A "=.==># / >).< <4D @ =.DD / >).< <4).D< E >).<

Pa : Pb

Therefore % : "0o 6 P 6 7# $e r%

Co"&'!()o" :

*e can conclude that the put - call parity is applicable only in 'uropean option and that too for options at the same strike price and at the same date of expiry. +n arbitrage situation exists if the parity e uation is not balanced. Fiven the price of the call option that of the put option can be calculated. In such case an investor can buy a portfolio which is lower priced and short the portfolio that is higher priced and makes risk free returns. Gere in the problem we can see that same arbitrage situation prevails so they buy the portfolio which is at lower price and short the portfolio that is at high price and made risk free profit.

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