No-Arbitrage Violations at Option Expiry
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maharjansandeep188No-Arbitrage Violations at Option Expiry
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Powered by AIThe maximum possible value of a call option equals the stock price because, in the extreme scenario of an exercise price being zero, the call would be equivalent to directly owning the stock. Hence, nobody would pay more for the call than the stock itself. Therefore, C(S₀, T, E) ≤ S₀. If this condition is violated and a call option trades above the stock price, an arbitrageur can profit by buying the stock and selling the call at a higher price .
The price of call options is inversely related to the exercise price. Lower exercise prices increase the potential benefit from exercising the call, making them more valuable to investors. Thus, Ca(S₀, T, E1) ≥ Ca(S₀, T, E2) where E2 > E1. This principle opens arbitrage opportunities if violated, allowing investors to sell higher-priced calls (higher exercise prices) and purchase lower-priced calls (lower exercise prices), or vice versa, to realize arbitrage profits .
The minimum value of an American call option is determined by its intrinsic value, which is the greater of zero or the difference between the stock price and the exercise price, formulated as Max[(S₀ - E), 0]. If the market price of an American call is less than its intrinsic value, an arbitrage opportunity arises. An investor can buy the call at a price lower than the intrinsic value and immediately exercise it to secure the intrinsic value, thus realizing an arbitrage profit .
The relationship that a longer-lived American call must be valued at least as much as a shorter-lived call (Ca(S₀, T2, E) ≥ Ca(S₀, T1, E) for T2 > T1) can lead to arbitrage if violated. An arbitrageur can exploit this by simultaneously selling the overpriced short-maturity option and purchasing the undervalued long-maturity option, thereby securing a profit without net risk, exploiting discrepancies in time value decay .
The value of a call option increases with longer time to expiration because the time value is based on the uncertainty of the stock's future price. Thus, a longer-lived American call must be worth at least as much as a shorter-lived American call with identical terms, i.e., Ca(S₀, T2, E) ≥ Ca(S₀, T1, E) where T2 > T1. If a shorter-lived call's price exceeds that of a longer-lived one, an arbitrage opportunity is present. Investors can sell the short-term call and buy the long-term call, allowing them to make a riskless profit .
Arbitrage opportunities arise if the European call option's price falls below its lower bound of Max[So - E(1 + r)^-T, 0] for non-dividend-paying stocks. This pricing discrepancy allows arbitrageurs to profit by buying the underpriced call option while shorting the equivalent stock, thereby reaping a riskless gain. The economic logic reflects that call options should not price significantly lower than the present value of their expected payoff .
The intrinsic value of a put is the greater of zero or the difference between the exercise price and the stock price (Max(0, E - S₀)), setting a floor for the option's price. The maximum price of an American put is capped by the exercise price itself (Pa(S₀, T, E) ≤ E). These constraints imply that the put’s price must always fall between these two values; otherwise, market mispricing would present arbitrage opportunities .
Dividends reduce the lower bound of a European call option because they effectively lower the future value of the stock by the dividend's present value. Thus, the lower bound is calculated as Max[So* - E(1 + r)^-T, 0] where So* accounts for the present value of dividends subtracted from the stock price. Arbitrage arises when the call's market price falls below this adjusted bound, allowing profit by buying the call and selling short the stock .
At expiration, put options are worth their intrinsic value because there is no remaining time value, and the value is determined by the difference between the exercise price and stock price, i.e., Max(0, E - ST). If mispricing occurs, where the market price is less than the intrinsic value, it creates arbitrage opportunities to buy undervalued puts and instantly exercise them for a risk-free profit. Conversely, if priced higher, selling the overpriced put allows profit taking .
The time value of an American call option is the difference between its market price and intrinsic value, reflecting the premium investors are willing to pay for uncertainty regarding the underlying stock. As the option nears expiration, its time value decreases, or 'decays,' and becomes zero upon expiration, where the market price equals the intrinsic value .