PUT-CALL PARITY

By: Shruti Agrawal-201 Suhas Anjaria-202 Kankana Dutta-205 Aabhas Garg-207

Introduction
Put-call parity is an important principle in options

pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. Support for this pricing relationship is based upon the argument that arbitrage opportunities would materialize if there is a divergence between the value of calls and puts. Arbitrageurs would come in to make profitable, riskless trades until the put-call parity is restored.

 Let's take a look at two portfolios, A and B.

Portfolio A = European Call + Cash, where Cash = Call

Strike Price Portfolio B = European Put + Underlying Asset European Call + Cash = European Put + Underlying Asset

 If the two portfolios have the same expiration value,

then they must have the same present value. Otherwise, an arbitrage trader can go long on the undervalued portfolio and short the overvalued portfolio to make a risk-free profit on expiration day.

Put-Call Parity: Payoffs at Expiry

$100.00 $80.00 $60.00 $40.00 $20.00 $$$(20.00) $50.00 $100.00

Long 1 Share Long 1 put Long 1 Call Exercise Price P+S C+X

The Put/Call Parity Relationship (contd)

Equilibrium Stock Price Example
You have the following information: Call price = $3.5 Put price = $1 Striking price = $75 Riskless interest rate = 5% Time until option expiration = 32 days

If there are no arbitrage opportunities, what is the equilibrium stock price?

6

The Put/Call Parity Relationship (contd)

Equilibrium Stock Price Example (contd)
Using the put/call parity relationship to solve for the stock price: K S0 C P (1 r ) t $75.00 $3.50 $1.00 32 (1.05) 365 $77.18

Put Call Parity with Dividends

As we know stocks pay dividends and these dividends affect

the future valuation of the stock as money is being taken out of the company and paid to its' shareholders. Because options have an expiration date, we need to value the option not against the current price of the stock but against what the expected value will be at the expiration date. This is known as the forward price. Let's take the basic put call parity formula
Call - Put = Stock - Strike.

And finally, as the strike price is the expected exercise price in

the future we need to discount that value by the interest rates to a present value by dividing the strike by e ^ rt.
Call - Put = (Stock -Dividends) - PV(Strike)

Or, simplified;

Put Call Parity - The Reality of Put Call Disparity

Put Call Parity requires that the extrinsic value of call and put options of

the same strike price to be the same. However, in reality, the extrinsic value of put and call options are rarely in exact parity in option trading even though market makers have been charged with the responsibility of maintaining Put Call Parity. When the outlook of a stock is bullish, the extrinsic value of call options tend to be higher than put options due to higher implied volatility and When the outlook of a stock is bearish, the extrinsic value of put options tends to be higher than call options. Deviations from Put Call Parity or Put Call Disparity has also been used in the analysis of future stock prices as stocks with relatively expensive calls have been found empirically to outperform stocks with relatively expensive puts by a measurable significance and margin.

Examples
Let's look at some real world examples of put call

parity to understand how prices fit together. Take a look at the option series below for Infosys Ltd. Taking the following strategy
Long (buy) call Short (write) put Sell (short) 1 share

Invest amount equal to strike price @ risk free rate

of return, 8 %

In the Money Call

Today's Date Expiration Date Days to Expiration Interest Rates Stock Strike Put Discount Factor Call = Call = Actual Market Price Difference 27-03-2014 24-04-2014 28 8.00% 3,278.15 3,200.00 94.00 1.00592132 Stock - PV(Strike) + Put 190.98669488 165.65 25.3366949

Clearly there exists a put call disparity Call will be exercised so in this case arbitrage profit will be:
Call premium Exercise call 3200 Put Premium Put expires worthless Sell one share Receive Invest amount = -165.65 =-

= 94
= 0 = 3278.15 = 3218.95

Out of Money Call

Today's Date Expiration Date Days to Expiration Interest Rates Stock Strike Put Discount Factor Call = Call = Actual Market Price Difference 27-03-2014 24-04-2014 28 8.00% 3,278.15 3,350.00 162.50 1.00592132 Stock - PV(Strike) + Put 110.36966496 96.45 13.9196650

Clearly there exists a put call disparity Put will be exercised in this case arbitrage profit will be:
Call premium Call expires worthless Put Premium Put exercised against you 3350 Receive Invest amount 3369.84 = -96.45 =0 = 162.50 = =

= 85.89

Reliance call put parity

If we rearrange the put call parity equation to solve for the call option we have; Call = Stock PV(Strike) + Put , entering in the values from the market
Stock price 891 891 891 891 891 891 891 891 Strike price 940 920 900 880 860 840 820 800 Put Actual call premium Call = stock + put - PV(strike) 45 28.5 10.5 1.65 0.1 0.2 0.1 0.2 0.25 0.55 4.5 14 30.5 52.45 72 91 -3.80469317 -0.308848635 1.686995901 12.83284044 31.27868497 51.37452951 71.27037404 91.36621858 Difference In call price -4.05 -0.86 -2.81 -1.17 0.78 -1.08 -0.73 0.37

If we rearrange the put call parity equation to solve for the call option we have; Call = Stock PV(Strike) + Put , entering in the values from the market
Stock price 891 Strike price 820 Put 4.95 Actual call premium 85 Call = stock + put Difference In call price - PV(strike) 81.19008621 -3.81

891
891 891 891 891

840
860 880 900 920

7
11 16.95 27.2 38.75

68
52 37 27.35 19

63.36789319
47.49570017 33.57350716 23.95131414 15.62912112

-4.63
-4.50 -3.43 -3.40 -3.37

Put-Call Parity in other markets

Maturity 24/04/14 17/05/14 21/06/14 19/07/14 Stock Price 35.92 35.92 35.92 35.92 Yahoo! Inc. (YHOO) -NasdaqGS Implied Call Strike Price Put Premium Premium 37 37 37 37 1.98 2.63 3.1 3.56 1.01 1.77 2.35 2.93 Actual Call (Ask) 0.91 1.55 2.11 2.6 Arbitrage 0.10 0.22 0.24 0.33

* 91 Day T-bill auc rate : 4.5%

Issues with trading using PCP

High transaction costs wipe out small arbitrages

Requires Shorting : Hard to borrow stocks cannot

be used
Naked shorting is illegal. Opportunity window

becomes smaller
Locking up of capital : in far-month calls
Difficult to estimate gains/losses while using

American Options
Arbitrage exists in an upper & lower band for

American options

Factors Behind the Violation of put-call parity theorem

Arbitrage profits are more in case of : Deeply ITM or deeply OTM options and
ITM put options generate more arbitrage profits in case of

less liquid options and for near the month option contracts where as OTM put options generate more arbitrage profits for not so near the month contracts
Longer time to maturity
longer the time to maturity of the option, higher the arbitrage

profit. That is, arbitrage profits are more in case not so near month contracts than near the month contracts

 Number of Options traded: In case of number of options traded are 100 or more, arbitrage profits are more in case of ITM put option than OTM put option. Number of Contracts traded: It shows that in case of less liquid options higher the number options traded with in less liquid options, lower the arbitrage profits and vice versa. In case of high liquid options, higher the number of contracts traded, higher the arbitrage profits and vice versa. Regarding the moderate liquid options, the coefficient of number contracts traded came out to be insignificant which shows that number of contracts traded with in moderate liquid options does not influence the arbitrage profits.

Thank You