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Put-Call Parity Model Explained

The Put-Call parity model relates the values of four securities: a call option, a put option with identical terms, the underlying stock, and a risk-free asset maturing at the option expiration date. It is used to value call options relative to puts and show how the payoffs of any security can be replicated by positions in the other three. The model states that the stock price plus the put price should equal the discounted strike price plus the call price. Violations of put-call parity can be arbitraged by buying the cheap portfolio and selling the expensive one.

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17 views3 pages

Put-Call Parity Model Explained

The Put-Call parity model relates the values of four securities: a call option, a put option with identical terms, the underlying stock, and a risk-free asset maturing at the option expiration date. It is used to value call options relative to puts and show how the payoffs of any security can be replicated by positions in the other three. The model states that the stock price plus the put price should equal the discounted strike price plus the call price. Violations of put-call parity can be arbitraged by buying the cheap portfolio and selling the expensive one.

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api-3763138
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© Attribution Non-Commercial (BY-NC)
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PUT - CALL PARITY MODEL

The Put - Call parity model is based on expiration date investment values associated
with four different securities: (1) Call Option; (2) Put Option with Identical Terms;
(3) Spot Asset (Security on which options are written); and (4) Risk-Free Security
With Maturity Date Identical to Options' Expiration Date and Maturity Payment
Equal to the Options' Exercise of Strike Price (zero coupon bond).

Put - Call Parity is Used for Two Purposes:

1. To Value a Call Option Relative to a Put With Identical Terms

2. To Show How the Expiration Date Payoffs on Any One of These 4


Securities Can be Replicated by Taking Appropriate Positions in the
Other 3 Securities (i.e., creating synthetic securities).

Put - Call Parity Model


S0 + P0 = [X / (1 + RF)T] + C0

Stock Plus Put Equals T-Bill Plus Call

Synthetic Securities

Asset to Replicate The Replicating Portfolio

Buy Risk-Free Asset + X / (1 + RF)T = + S0 + P0 - C0

Buy Call Option + C0 = + S0 - X / (1 + RF)T + P0

Buy Put Option + P0 = + C0 + X / (1 + RF)T - S0

Buy Asset (Stock) + S0 = + C0 + X / (1 + RF)T - P0


PUT - CALL ARBITRAGE STRATEGY

Stock 6 month 6 month Risk Free Strike Days to


ASSUME Price Call Price Put Price Rate Price Maturity
$110.00 $17.00 $5.00 10.25% $105.00 182

Cash Flow in 6 Months


Take Positions Immediate Cash Flow Stock < $105 Stock > $105

Buy Stock ($110.00) = + Stock = + Stock

Borrow RF Asset Equal $100.01 ($105.00) ($105.00)


to Discounted Strike Price

Sell Call $17.00 None = - (Stock - 105)

Buy Put ($5.00) =105 - Stock None

TOTAL $2.01 0 0

The Result is Violation of Put - Call Parity


Computer Generated Analysis
Should
Call + RF Asset Equal Stock + Put

$17.00 $100.01 $110.00 $5.00


$117.01 $115.00
Mispricing
$2.01

Strategy -----------> Buy Cheap Portfolio------------> Stock Plus Put


Sell Expensive Portfolio------> Write Call and Borrow RF Asset
Put - Call Parity Model
S0 + P0 = [X / (1 + RF)T] + C0

Stock Plus Put Equals T-Bill Plus Call

Input Price Quotations From Wall Street Journal for Call and Put

Company IBM

Date Purchased 11/3/1997 Date, e.g., 11/04/97

Date Option Expires ### Date, e.g., 12/19/97

Input Stock Price $101.625 In Dollars, e.g., $54.67

Input Call Price $9.500 In Dollars / Cents, e.g., $1.38

Input Put Price $2.625 In Dollars / Cents, e.g., $.675

Input Risk-Free Rate 4.090% As Decimal, e.g., .05 (S/T T-Bill Asked Discount Rate)

Computer Determines 46
Days to Expiration

Input Strike Price $95.00 In Dollars, e.g., $54.67

OUTPUT
Should
Call + RF Asset Equal Stock + Put

$9.500 $94.521 $101.625 $2.625


Sum Sum
$104.021 $104.250
PUT - CALL MISPRICING
($0.23)

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