FNCE90011 / FNCE90020

Derivative Securities

Topic 2

Arbitrage Bounds
Topic Outline

Pricing Factors
The Principle of Arbitrage
Upper and Lower Bounds: Options on Non-Dividend Paying Stocks
The Effect of Dividends
Optimal Exercise of American Options
Limits to Arbitrage

References

Hull (7th edition) Chapter 10

Hull (6th edition) Chapter 9
Hull (5th edition) Chapter 9
Copyright John C. Handley 2012.

1. PRICING FACTORS
Which Factors Determine the Value of an Option Prior to Maturity ?
We know that the value of an option at maturity is a function of two factors
the stock price at maturity ST and the strike price X .
In contrast, at any time prior to maturity, the value of an option is a function of
six factors

the current stock price at that time

strike price
time to maturity (i.e. remaining life of the option)
risk free interest rate (over the remaining life of the option)
expected dividends on the stock (over the remaining life of the option)
volatility in the future stock price (over the remaining life of the option)

Volatility
Volatility measures the dispersion in the possible future stock prices over the
remaining life of the option in other words, it reflects how uncertain we are
about the future price of the stock
A precise definition will be given in a later class, but for now

a low volatility means there is a low probability of either large

increases or large decreases in the stock price between now and maturity

a high volatility means there is a high probability of either large

increases or large decreases in the stock price between now and maturity

There is good news and bad news about volatility

the current value of an option is most sensitive to changes in volatility
but volatility is the only (pricing) factor which we cannot observe

Sensitivity Analysis
The impact of an increase in one factor, on the current value of a (long) option,
whilst holding all other factors fixed is
Pricing Factor

European Call

European Put

American Call

American Put

S
d
X

r
T

Note holding all other factors fixed means we are changing only one
variable at a time and so we are ignoring any possible interaction effects
between the various factors.
Optional Note: For example, when we assume an increase in current stock price we do not allow for any
possible change in volatility. Empirically we find that prices are negatively correlated with volatility so there is
tendency for price increases to be associated with decreases in volatility.
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For example

stock price
The higher the current stock price the higher the expected stock price at
maturity the higher the expected value of a call option at maturity
the higher the current value of a call option

dividends
The higher the dividend the lower the expected stock price at maturity

strike price
The higher the strike price the more you have to pay to exercise a call
option at maturity the lower the expected value of a call option at
maturity the lower the current value of a call option

Example from last week Bull Spread Using Calls

volatility
The higher the volatility the higher the probability of a big positive payoff

Prob of large in S

Impact on
Long Stock Long Call

Long Put

Prob of large in S

Net effect
Optional Note: The impact of changes in interest rates and time to maturity is more complicated. A higher
interest rate lowers the strike price in present value terms which on its own has the same effect as a lower strike
price but interest rates also tend to be negatively correlated with stock prices. Increasing the time to maturity
has two effects on European options it reduces the present value of the strike price but it also increases the
likelihood of favourable outcomes for both calls and puts. In the absence of dividends, the two effects operate in
the same direction for calls but not for puts. Further ambiguity can arise in the case of a European call on a
dividend paying stock. For American options, increasing the maturity adds additional flexibility and so increases
the value of both calls and puts.
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2. THE PRINCIPLE OF ARBITRAGE

Arbitrage
An arbitrage is a trading strategy which costs nothing today but has the
expectation of a cash inflow later with no chance of a cash outflow later.
Also called a free lunch or something for nothing
Compare the pattern of cash flows on the following trading strategies:
Trading Strategy
Buy shares now and sell them later
Short sell shares now and buy them back later
Arbitrage strategy I
Arbitrage strategy II
Arbitrage strategy III
Arbitrage strategy IV

Cash Now

Cash Later

0
0

only in some states of the world

and zero in all other states

The trading strategy usually involves the sale of one or more assets at a
relatively high price and the simultaneous purchase of the same assets (or
their equivalent) at a relatively low price.
In seeking to exploit an arbitrage opportunity, the buying and selling actions of
investors drives the prices together until the arbitrage disappears.
The Law of One Price (LOOP)
Assume the current (time 0) price of asset X is X 0 and the current price of
asset Y is Y0 . Further assume that the random payoff on asset X at time 1 is
X1 and the random payoff on asset Y at time 1 is Y1 .
LOOP states if X 1 Y1 then X 0 Y0 otherwise an arbitrage opportunity is
available
i.e. if two assets have identical cash flows in the future then they must
trade at the same price today
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Assume X 1 Y1 . What does LOOP tell us ?

So what would you do if you observe that X 0 Y0 ?

Action

Cash Now
t 0

Cash Later
t 1

Net Cash flow

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LOOP is a statement about the relative prices of two or more assets

in the above case, the action of arbitrageurs would create selling pressure
on X (which would drive down its price) and create buying pressure on Y
(which would drive up its price) until the prices of the two assets equate
and no further arbitrage is possible. Note, LOOP says the prices equate
but it says nothing about at which price this will occur.
An Important Application of LOOP Valuation By Replication
If you can replicate (or copy) the future cash flows on one asset (or portfolio of
assets) using the cash flows on some other asset (or portfolio of assets) then
the current value of the first is equal to the current value of the second
otherwise there is an arbitrage
sometimes a static replication is used you replicate the cash flow by
setting up the appropriate strategy at the start of the period (and then
settle at the end)
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sometimes a dynamic replication is used you replicate the cash flow by

setting up the appropriate strategy at the start of the period and you
periodically rebalance the strategy over the period and then settle at the
end.
Replication and hedging are related concepts you can hedge a long position
in an asset by replicating a short position in that asset more on this in a
later class
The Assumption of No Arbitrage (NA)
Arbitrage is a fundamental force in financial markets
Arbitrage opportunities should be rare in well functioning financial markets
with rational investors who prefer more wealth to less
But when an arbitrage does arise, it tends to disappear very quickly as the
buying and selling actions of investors cause the relevant asset prices to
adjust why ?
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NA can be used in a number of ways including

establish (upper and lower) bounds on the price of one or more assets
derive the price of an asset

In fact, many standard pricing models used in practice (such as those dealing
with options, futures, interest rates, foreign exchange rates) are based on an
assumption of NA
Optional Note: Relationship between LOOP and NA: LOOP is an important special case of NA (equivalently NA
is a more general concept than LOOP) because arbitrage is not restricted to circumstances where the two
assets have identical payoffs. NA is a necessary condition for equilibrium in a financial market i.e. without NA
then equilibrium is not possible or equivalently, if an arbitrage exists then by the market cannot in equilibrium
(since there will be an excess demand for at least one asset and an excess supply for at least one other asset)

Arbitrage and Risk Arbitrage

A (pure) arbitrage is one where the investor expects to make a gain with no
risk. A risk arbitrage involves an element of speculation (usually concerning
the relative mispricing of one or more assets) and so involves some risk

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Put-Call Parity (PCP)

Established by arbitrage arguments
Consider a European call option and a European put option on a stock both
with a strike of X and maturity T years from now. Assume the current stock
price is S , the risk-free rate is constant at r % per annum and the stock is not
expected to pay any dividends over the next T years. Then, in the absence of
arbitrage:
C E PE S Xe rT

where CE is the current price of the call and PE is the current price of the put.

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Derivation
Consider the following two portfolios:

you buy the call and sell the put

you buy the stock and borrow an amount equal to the PV of the strike for
T years at an interest rate of r % per annum
Action

Cash Now

Cash at Maturity
ST X
ST X

Buy call
Sell put
Net
Buy stock
Borrow
Net
LOOP the current values must be the same otherwise there is an arbitrage
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Other versions of Put-call parity

Different versions of PCP apply in the case of American options and / or when
there are dividends e.g.

PA S D X C A PA S Xe rT
3. UPPER AND LOWER BOUNDS: OPTIONS ON NON-DIVIDEND
PAYING STOCKS
Assumptions

frictionless markets
(nominal) interest rate r 0
no arbitrage

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Upper Bound on Value of a (Long) Call

C E S and

CA S

The maximum possible payoff (at some time t ) on a call occurs if the strike
price is zero f t max [0, S t ] S t and (in the absence of dividends), the PV of
S t is equal to S irrespective of t
Upper Bound on the Value of a (Long) Put

PE Xe rT

and

PA X

The maximum possible payoff (at some time t ) on a put occurs if the stock
price is zero at that time f t max [0, X ] X and the present value of X will
depend on t
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Lower Bound on Value of a European Call

CE max[0, S Xe rT ]

. otherwise there is an arbitrage

1. Example
Consider a 1-year European call (strike $18) which currently trades for $3.00.
The current stock price is $20 and the risk free rate of interest is 10% p.a.
ACTION

t=0

t=T=1

ST 18

ST 18

Net Cash
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Note that an alternative strategy is

ACTION

t=0

t=T=1

ST 18

ST 18

Net Cash

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2. How do you identify the arbitrage opportunity ?

Assume

CE S Xe rT

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3. Modus Tollens
A rule of logic which states .
If

A B

then

not B not A

4. Derivation of bound

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Lower Bound on Value of a European Put

PE max[0, Xe rT S ]
The derivation is similar to that used for the call

4. THE EFFECT OF DIVIDENDS

Assume investors know with certainty that one (or more) dividends will be paid
(on one or more ex-dividend dates) over the life of option
Let D be the present value of these dividends (discounted at the risk free rate)

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Lower Bound on European Call

CE max[0, S D Xe rT ]

Derivation is similar to the non-dividend case except now we need consider

cash flows at times 0,T and also on each ex-dividend date
Lower Bound on European Put

PE max[0, D Xe rT S ]
Optional Note: It can be shown that the upper bounds are tighter when there are dividends compared to the
non dividend case

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5. OPTIMAL EXERCISE OF AMERICAN OPTIONS

Key Question
A European option may be exercised only at maturity
An American option may be exercised at any time up to and including maturity
so under what circumstances, if any, would it be optimal to exercise an
American option early i.e. prior to maturity ?
The answer depends on whether

the option is a call or a put; and

the stock is expected to pay any dividends over the life of the option

In examining this question we can consider any of the possible exercise dates
0 t T prior to maturity for simplicity, lets choose now i.e. t 0
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The current value of a European option reflects the flexibility to avoid a loss on
the stock at the maturity date.
An American option gives you all the flexibility of an otherwise equivalent
European option (same stock, same strike price and same maturity) plus more
Enter Contract

Maturity

Possible
Exercise dates
European

American

the (current) value of an American option therefore equal to the (current)

value of an otherwise equivalent European option plus the (current) value
of the additional flexibility of being able to exercise early
C A C E ECE
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We can state a corresponding relationship for put options

PA PE EPE
Optional Note: For more on this early exercise premium representation of American options see Carr, Jarrow
and Myneni, 1992, Alternative Characterisations of American Put Options, Mathematical Finance, 2, 87-106.

In general, the owner of an option would exercise an American option early

only if it the (expected) incremental benefit of doing so exceeds the
(expected) incremental cost of doing so.
Recall in the absence of dividends, the PV of the future stock price S t is
equal to the current stock price S (irrespective of t ) in other words, the
current stock price represents the current value of a claim on the stock at
some time in the future. This means that in comparing exercise now verses
exercise later, the only expected incremental benefit or cost associated with
exchanging a stock now verses exchanging a stock later are any dividends to
be paid on the stock over the life of the option.
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Subject to one important exception (discussed below), determining the value

of an American option is much more complicated than determining the value of
an otherwise equivalent European option
(i) American Call on a Non Div Paying Stock
1. Rule
It is never optimal to exercise the option early

2. Valuation Implication:
C A CE

and so we can value the American call as if it was a European call

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3. Intuition:
If you exercise the call option now you

pay the strike now rather than (possibly) later

give up the option to exercise later

So should you exercise early ?

4. Lower Bound:

C A max[0, S Xe rT ]
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5. Formal Proof:
Compare exercise the call now t 0 verses do not exercise now
If exercise now at t 0 then

C Aexercised S X

If do not exercise at t 0 then

CAunexercised CE
but we know that CE max[0, S Xe rT ]
where CE is an otherwise equivalent European call
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Positive interest rates imply that

S Xe r T S X

Combining leads to

CAunexercised CAexercised

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(ii) American Put on a Non Div Paying Stock

Rule:

It may be optimal to exercise the option early

Valuation Implication:

PA PE

Lower Bound:

PA max [0, X S ]

(iii) American Call on a Div Paying Stock

Rule:

It may be optimal to exercise the option just prior to an ex-div date.

Valuation Implication:

C A CE

Lower Bound:

C A max[0, S D Xe rT , S X ]

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(iv) American Put on a Div Paying Stock

Rule:

It may be optimal to exercise the option except just prior to an ex-div

date.

Valuation Implication:

PA PE

Lower Bound:

PA max[0, D Xe rT S , X S ]

6. LIMITS TO ARBITRAGE
Standard NA models are based on a number of simplifying assumptions
but in reality, there are a number of market features which may introduce
risk into what otherwise would be a pure arbitrage opportunity
and in turn this limits the ability of arbitrageurs to take full take advantage
of the apparent arbitrage,
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For example, there are

various restrictions on short selling of assets - eg, the need to post

collateral limits access to the whole proceeds from the short sale

possibility of margin calls - eg, it is assumed that the prices of two perfect
substitutes will converge but this may not occur exactly or may not
occur within the investors time horizon or prices may first diverge before
converging

execution risk eg delays in implementing the required trades on a

simultaneous basis

model risk eg standard option pricing models are based on some

assumed model of asset prices but is this correct !

and of course .there is always counterparty default risk

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