Table of Contents

1. What is Arbitrage? Why options are considered non-arbitrage price relations? 2. Describedifferentkindsofnonarbitragepricerelations. Whataretheirmajorfeaturesanddifferences? 3. What is the European-Style option? What are the different kinds of options traded in European-Style way? 4. Bibliography

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WhatisArbitrage?Whyoptionsareconsiderednonarbitragepricerelations? AccordingtoDamodaran,purearbitrageinvolvesinvestingnofunds,takingnorisks andwalkingawaywithsureprofits.(Damodaran,2002).Hefurtherclassifiesthem aspurearbitrage,neararbitrageandspeculativearbitrage.Purearbitrageiswhere theinvestorrisksnothingandearnsmorethantheriskfreeprofit,neararbitrageis whentherearetwoidenticalassetswithalmostidenticalcashflows,althoughthere is no guarantee that there prices will converge and finally speculative arbitrage is when the investor thinks that there are similar but mispriced assets that the investorwishestotakeadvantageofbuyingthelowerpricedassetandsellingthe higherpricedone. In the context of options, arbitrage is easily possible since there is usually an underlyingassetalongwiththederivative,thususingacombinationoftheassetand the option one can construct a riskfree position. When options violate the simple price bounds an arbitrage opportunity will arise i.e. when the option sells for less thanitsexercisevalueanarbitrageopportunitywillexist.Fore.g. Foracalloption:valueofcall>valueofunderlyingstrikeprice Foraputoption:valueofput>strikepricevalueofunderlying. Thus if you had a call option with a strike price of US$ 60, currently trading at US$70,thecallpriceshouldbeatleastUS$10otherwiseanarbitrageopportunity willexist,whereyoucanbuythecalloptionforlessthanUS$10andexercisethe calltomakeanetgain.

Amongst option pricing models the Binomial option pricing model is a powerful technique that helps solve complex optionpricing problems. As opposed to the otherpricingmodelsthatrequirestochasticdifferentialequations,binomialoption pricingisbasedonsimplemathematicsandontheassumptionofnoarbitrage. Thisassumptionimpliesthatriskfreeinvestmentscanearnriskfreeratesofreturn and there do not exist any investment opportunities with zero dollar investments yielding a positive return. The activity of many financial market participants who operate in the context of these markets, in fact, uphold this condition of no arbitrage. Whilst media maligns the activities of these arbitrageurs or speculators it is often theywhoensurethatthefinancialmarketswork.Thattheoptionpricesremainwith in a tolerance limit of their theoretical value are also ensured by their trading activities. (Conroy, 2003)

Describedifferentkindsofnonarbitragepricerelations.Whataretheirmajor featuresanddifferences? In the context of options nonarbitrage price relations have 3 to 4 types namely upper and lower bounds, putcall parity relations and intermarket relations, (Whaley, 2006) when options prices are breaching these bounds arbitrage or risk freeprofitopportunitiesarise. (Hull, 2006). Upperboundsofoptionprices CalloptionsbothAmericanandEuropeangivetheholdertherighttobuythestock for a certain price, under no circumstances the option would be worth than the stocki.e.theupperboundoftheoptionpriceisthestockprice,ifthatisnotthecase an arbitrageur could make a riskless gain by going long the stock and selling the option.ThusifcisoptionpriceofaEuropeancallCthatofanAmericancalland Sothecurrentstockpricethen;cSo&CSo,soalsopK&PK,whereKisthe strike price and p & P are prices of the European and American put for a stock respectively.ItisalsotruethattheEuropeanputpricetodaywillbeworthlessthe present value of the strike price i.e. p K erT thus if the put option price where greaterthanthestrikepricethearbitrageurcouldwriteaputandtheproceedsof thesalecouldbeinvestedattheriskfreerate. (Hull, 2006) Lowerboundsofoptionprices TostartwithanAmericancalloptioncanbeexercisedatanytimeduringthelifeof theoptionhenceforanAmericancallCwiththesametimetoexpirationandstrike onthesameunderlyingshouldbeworthmorethantheEuropeancallc.

ItisalsoquiteobviousthatthepriceofeitherCorccannotbe<0sinceyoudo nothavetopaysomeonetotakeaprivilege. DerivingLowerboundsforcalls; Let us consider a portfolio A that includes a European call option and a certain amountofcashthatequalsthepresentvalueofthestrikepriceofthecall,KerT;and anotherportfoliothathasoneshareofthesameunderlying. (Hull, 2006) ForportfolioAthecashinvestedatrtheriskfreeratewillhavegrowntoKatthe time ofexpirationT.If ST > K thenthe callcanbeexercisedand the portfolioA at maturity of the option will be ST. If ST < K the option expires worthless and the portfoliostillhasavalueK.ThusattimeTportfolioAisworthmax(ST,K).Portfolio B at time T will be worth ST. Thus portfolio A will be worth at least as much as portfolio B and can be worth more at maturity of the option. Thus under non arbitragecircumstancesthesesamevaluedifferencesshouldholdtodayi.e. c+KerTSoorcSoKerT. Sincetheworstthatcanhappentocalloptionisexpireworthlessitsvaluecannotbe negativeasexplainedearlier.Hencec0andtherefore cmax(SoKerT,0). DerivingLowerboundsforputs; LetusnowconsideraportfolioC:madeupof1Europeanputoptionplus1share and portfolio D: which contains cash equal to KerT i.e. cash that will grow to the strikepriceoftheputatexpirationoftheoptionattimeT.

IfST<KtheoptionwillbeexercisedatmaturityforportfolioCandportfoliovalue willbeK,howeverifST>Ktheoptionwillexpireworthlessandtheportfoliosvalue willbeST.ThusportfolioCwillbeworthmax(ST,K)attimeT.InportfolioDthecash being invested at the riskfree rate will result in value K. Thus portfolio C will be worthattheleastasmuchasDandsometimesmoreattimeT.Henceundernon arbitragecircumstanceportfolioCshouldbeatleastasmuchasportfolioDtoday. p+SoKerTorpKerTSo again the lowest price of the put i.e. the worst that can happen to put is that it expiresworthlessi.e. pmax(KerTSo,0). PutCallParity Another important relationship between a European put and a call is the putcall parityequation,whichstatesthevalueofaEuropeancallplusthePVofthestrike price will be equal to put price with the same strike and expiration date plus the stockpricetoday. WhilstderivingthelowerboundsoftheEuropeancallandputwededucedthatboth PortfolioA:containingoneEuropeancallplusthePVofthestrikeprice;KerT& Portfolio C : containing one European put and one share of the same underlying stock both were worth max (ST, K) since these are European option which can be exercisedonlyatexpiry,theportfoliosmusthaveidenticalvaluestodayi.e. c+KerT=p+S0. This relationship referred to as putcall parity where the value of a European call withacertainstrikepriceandexercisedatecanbededucedfromtheEuropeanput

with the same strike and exercise date this also applies viceversa. An arbitrage opportunity will arise if the equation does not hold, i.e. when the left side of the equation is overpriced in our case portfolio A, then we short the securities in portfolioAandgolongtherightsidei.e.portfolioCtolockinaprofitandviceversa. Studies options traded in 1977 & 1978 in the CBOE violated the put-call parity, but these violations were small and were observed only for short periods. RecentstudiesbyKamara and Miller of European options on the S&P 500 between the years 1986 and 1989 found fewer violations of put-call parity however the deviations tended to be small, despite the violations. (Damodaran, 2002) LowerBoundsofanAmericanstyleCall; AnAmericanstyleasstatedaboveismorevaluablethanaEuropeancallduetothe additionalprivilegeofanytimeexerciseduringthelifeoftheoptionthevalueofthe Americancallis(Whaley, 2006) Cmax(S0KerT,SK,0) TheadditionalSKisbecausethecallcannotsellforlessthanitsexerciseproceeds throughoutitslifeSK,ifitdoesi.e.C<SK then there would be a riskless profit S K C, in buying the call, exercising the optionandsellingthestock. EarlyExerciseAmericanCalloptions AnAmericancalloptiononanondividendpayingstockshouldneverbeexercised before the expiry because this would not be an optimal solution for the following reasons, if it is not going to pay any dividends deferring exercise until expiration date earns some interest income at least at the riskfree rate on exercise price.

Additionallyifthereisanetcosttoholdtheunderlyingasseti.e.storagecostsetc. then deferring exercise until expiration allows the holder a claim on the asset withouthavingtoholdtheassetbytakingdeliveryandincurringstoragecosts. However on assets where there is a probable dividend income or forex options resulting in an underlying currency, that could earn interest, exercising the option maybeworthwhileifdividendsorinterestincomefromtheunderlyingmayhaveto beforfeitediftheoptionisnotexercised.HenceforAmericanCalloptionswithanet income from holding the underlying, exercising might be the optimal solution and thereforeC>c. (Whaley, 2006) EarlyExerciseAmericanputoptions For American put unlike the call there are no issues of carry costs or interest income.Earlyexerciseoftheoption,i.e.fortheAmericanputthereisalwayssome prospect,e.g.ifthepriceoftheunderlyingfallsto0exercisingimmediatelysince assetpricecannotfallanyfurther,willallowtheholderoftheputtoearninterest income.Thusinterestinducedearlyexerciseworksintheexactoppositemannerfor theputascomparedtothecall.(Whaley, 2006)

What is the European-Style option? What are the different kinds of options traded in European-Style way? A European style option contract allows exercise only at expiration date, which differs from an American option which can be exercised at any time during the life of the option. This key ability is what separates European options from other kinds. These are usually traded over the counter though index options trade on exchanges. Generally index options tend to be European style whilst all equity options are American. Pricing and valuation are easier and less complex due to limited exercise dates i.e. at expiry, which eliminate the uncertainty due to early execution. They also tend to be slightly cheaper for the same reason. They also tend to trade at a discount relative to their intrinsic value due to the need to wait to receive full value on execution at expiry. A deep in the money European option which expires after a few months may sell at a discount to its fair value. Whilst Asian options are based on the average value of the underlying, European options tend to be valued over specified time period using the price of the specific underlying. European options do not have call provisions like Bermudan options which allow the issuer to call the security at discrete points after a certain date. (Rice, 2008)

Europeanstyleoptionsaresimilartowarrantsastheycanbeexercisedonlyat maturity.InfactEuropeanoptionsgetexercisedautomaticallyonexpirationandare morelikefuturescontractsinthattheygetexercisedwheninthemoney.Theycan besoldatanytimeuptoonedaybeforeexpirationsincetheystoptradingaday beforeexpiration. 9

MostoptionsthattendtobesettledincashareEuropeanstyleoptions.Henceindex optionswhereitisalmostimpossibletodeliverallthestocksintheindexare usuallyEuropeanOptionswhilstphysicallysettledstockoptionstendtobe American.(Optiontradingpedia.com,2010) OfflateEuropeanoptionsalongwithAmericanonestradeonthesamephysical underlyinge.g.someforexfuturesoptions.Thisgiveswritersofoptionstheability towriteEuropeanoptionsthatdonothavetheriskofearlyexercise.Also assignmentriskbornebyAmericanoptionswritersisnotbornebywriting Europeanstyleoptions.Sincetheystoptradingthedaybeforeexpirationitisnot possibletosellthemimmediatelybeforeexpirationwhengainsmightbehighest. SettlementpricesofEuropeanoptionsgothroughamarkingtomarketprocess similartofuturestradingbeforethefinalsettlementpriceisdeterminedwhilst Americanoptionsusethefinaltradedpriceassettlementprice.TheEuropean optionspriceistypicallyreleasedafewhoursafterexpirationcreatingasuspense onthefinalprofit/lossfortheoptionsthathaveendedslightlyoutofthemoneyor atthemoney.

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Bibliography
Conroy,R.M.(2003).BinomialOptionpricing.Charlottesville,Viriginia,USA. Damodaran,A.(2002,October12).www.damodaran.com.FromDamodaranOnline: pages.ster.nyu.edu/adamodar/ Hull, J. C. (2006). Options, Futures and Other Derivatives (6th Edition ed.). Upper SaddleRiver,NewJersey,USA:PrenticeHall. Optiontradingpedia.com.(2010).EuropeanStyleoptions. Rice,D.F.(2008,November20).ExploringEuropeanOptions. Whaley,R.E.(2006).DerivativesMarkets,ValuationandRiskManagement.Hoboken, NewJersey,US:JohnWiley&Sons.

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