Chapter 8

(Chapter 9 in the
textbook)
Parity and Other
Option Relationships
 Points to Note
1. Important relation: Put-call parity. See P.5
2. Generalized put-call parity on exchange options. See P.9
3. The relationship between call and put options on exchange rate.
See P.16
4. Compare the prices of European and American options. See P.17
5. The upper and lower bounds of the option price. See P.18 – 19
6. Early exercises of American call and put options. See P.20 – 25
7. Relationship between time to expiration and option price. See P.
26
8. Relationship between strike prices and option prices. See P.27 -
32
9. Exercise and Moneyness. See P.33 – 34.

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 IBM Option Quotes

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 Put-Call Parity
Important Note: Starting from here, the meaning
of T in F0,T is changed to mean the maturity date of
the forward contract.

Notations:
• C(K, T) and P(K, T) are the prices of a European
call and put with the strike price K and the time
to expiration T respectively;
• Ft,T be the time t price of the forward contract with
the maturity date at time T.

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 Put-Call Parity (cont’d)
For European options with the same strike price and
time to expiration the parity relationship is
Call – put = PV (forward price – strike price)
Or
C ( K , T  t )  P( K , T  t )  e r T t  ( Ft ,T  K )

• In general, put-call parity fails for American style

options.

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 Parity for Options on Stocks

• If underlying asset is a stock and PVt,T(Div) is the

present value of the dividends payable over the
interval (t, T), then e-r(T t) Ft,T = St – PVt,T (Div),
therefore
C ( K , T  t )  P ( K , T  t )  [ St  PVt ,T (Div)]  e r T t  ( K )
• For index options or stock with dividend yield ,
 T  t 
C ( K , T  t )  P ( K , T  t )  St e  PVt ,T ( K )

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 Parity for Options on Stocks
(cont’d)
• Examples 9.1 & 9.2
– Price of a non-dividend paying stock: $40, r=8%, option strike
price: $40, time to expiration: 3 months, European call: $2.78,
European put: $1.99. $2.78=$1.99+$40 – $40e -0.08x0.25.
– Additionally, if the stock pays $5 just before expiration, call:
$0.74, and put: $4.85. $0.74-$4.85=($40 – $5e-0.08x0.25) –
$40e-0.08x0.25.

• Synthetic security creation using parity

– Synthetic stock: buy call, sell put, lend PV of strike and dividends.
– Synthetic T-bill: buy stock, sell call, buy put.
– Synthetic call: buy stock, buy put, borrow PV of strike and
dividends.
– Synthetic put: sell stock, buy call, lend PV of strike and dividends.

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 Generalized Parity and Exchange
Options
• Suppose we have an option to exchange one asset for another.
• Let the underlying asset, asset A, have price St, and the strike
asset, asset B, have the price Qt.
• Let Ft ,PT S  denote the time t price of a prepaid forward on the
underlying asset, paying ST at time T.
• Let Ft ,PT Q  denote the time t price of a prepaid forward on the
underlying asset, paying QT at time T.
• Let C(St, Qt, T – t) denote the time t price of an option with T–
t periods of expiration, which gives us the right to give up
asset B in exchange for asset A.
• Let P(St, Qt, T – t) denote the time t price of an option with T–
t periods of expiration, which gives us the right to give up
asset A in exchange for asset B.

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 Generalized Parity and Exchange
Options (cont’d)
• At time T, we have
C(ST, QT, 0) = max(0, ST – QT) and
P(ST, QT, 0) = max(0, QT – ST)

• Then for European options we have this form of the parity

equation:

C ( St , Qt , T  t )  P ( St , Qt , T  t )  Ft ,PT ( S )  Ft ,PT (Q)

• We also have C(St, Qt, T – t) = P(Qt, St, T – t).

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 Generalized Parity Relationship

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 Currency Options

• A currency transaction involves the exchange of one kind of

currency for another.
• The idea that calls can be relabeled as puts is commonplace in
currency markets.
• A term sheet for a currency option might specify
“EUR Call USD Put, AMT: EUR 100 million, USD 120 million”

It says explicitly that the option can be viewed either as a call

on the euro or a put on the dollar. Exercise of the option will
entail an exchange of €100 million for $120 million.
• A call in one currency can be converted into a put in the
other.

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 Currency Options (cont’d)
Example
Let xt be the price of €1 in USD at time t.

Suppose the current exchange rate is x0 = $1.25/€. Consider the

following two options:
1. A 1-year dollar-denominated call option on euros with a strike
price of $1.20 and premium of $0.06545. In 1 year, the owner of
the option has the right to buy €1 for $1.20. the payoff on this
option, in dollars, is therefore
max(0, x1 – 1.20)

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 Currency Options (cont’d)
2. A 1-year euro-denominated put option on dollars with a strike
price of 1/1.20 = €0.833. The premium of this option is
€0.04363. In 1 year the owner of this put has the right to give up
$1 and receive €0.833; the owner will exercise the put when $1
is worth less than €0.833. The euro value of $1 in 1 year will be
1/x1. Hence the payoff of this option is

 1 1
max 0,  
 1.2 x1 

BOTH the call and put options are exercised when x1 > 1.20.

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 Currency Options (cont’d)

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 Currency Options (cont’d)
In summary, we have
1 1 
C$ x0 , K , T   x0 KPf  , , T 
 x0 K 
where
C$(x0, K, T) is the price of a dollar-denominated foreign currency call
with strike K, when the current exchange rate is x0;
Pf(1/x0, 1/K, T) is the price of a foreign-currency-denominated dollar
put with strike 1/K, when the exchange rate is 1/x0.

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 Currency Options (cont’d)
Remark
1. The forward price (dollar-denominated) on the foreign currency
with the current spot exchange rate x0 is given by
 r$  rf T
F0,T  x0 e ,
where T is the maturity date of the forward contract and rf is the
annual continuously compounded risk-free interest rate on the
foreign currency.

2. Put-call parity
C$  x0 , K , T   P$  x0 , K , T   x0 e
 rf T
 Ke  r$T ;
1 1   1 1  1  r$T 1  rf T
C f  , , T   Pf  , ,T   e  e .
 x0 K   x0 K  x0 K

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 Properties of Option Prices

• European versus American Options

– Since an American option can be exercised at
anytime, whereas a European option can only be
exercised at expiration, an American option must
always be at least as valuable as an otherwise
identical European option
CAmer(S, K, T) > CEur(S, K, T)
PAmer(S, K, T) > PEur(S, K, T)

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 Properties of Option Prices
(cont’d)
• Maximum and Minimum Option Prices
– The price of a European call option:
• Cannot be negative, because the call need not be exercised.
• Cannot exceed the stock price, because the best that can
happen with a call is that you end up owning the stock.
• Must be at least as great as the price implied by put-call
parity using a zero put value.
S  C Amer ( S , K , T )  CEur ( S , K , T )  max[0, PV0,T ( F0,T )  PV0,T ( K )]

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 Properties of Option Prices
(cont’d)
– The price of a European put option:
• Cannot be worth more than the undiscounted strike price, since
that is the most it can ever be worth (if the stock price drops to 0,
the put pays K at some point).
• Must be at least as great as the price implied by put-call parity
with a zero call value.
K  PAmer ( S , K , T )  PEur ( S , K , T )  max[0, PV0,T ( K )  PV0,T ( F0,T )]

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 Properties of Option Prices
(cont’d)
Early exercise for American options
Calls on a non-dividend paying stock

Early exercise is not optimal if the price of an American

call prior to expiration satisfies
CAmer(St, K, T – t) > St – K

If this inequality holds, you would lose money by early-

exercising (receiving St – K ) as opposed to selling the
option (receiving CAmer(St, K, T – t) > St – K).

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 Properties of Option Prices
(cont’d)
No early exercise for American call option on non-
dividend paying stock.

Proof
From the put-call parity, we have
C Eur St , K , T  t   St  K  PEur St , K , T  t   K 1  e  r T t  
     
Exercise value Insurance against ST  K Time value of money on K

 St  K
Since CAmer  CEur, we have
C Amer  C Eur  St  K


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 Properties of Option Prices
(cont’d)
Early-exercising has the following effects:
1. Throw away the implicit put protection should the
stock later move below the strike price.
2. Accelerate the payment of the strike price.
3. (No early-exercise) The possible loss from
deferring receipt of the stock. However, when there
is no dividends, we lose nothing by waiting to take
physical possession of the stock.

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 Properties of Option Prices
(cont’d)
Exercising calls just prior to a dividend
If the stock pays dividends, the parity relationship is
C St , K , T  t   PS t , K , T  t   S t  PVt ,T Div   PVt ,T K 
 S t  K  PS t , K , T  t   K  PVt ,T K   PVt ,T Div 

Early exercise is not optimal at any time where

K  PVt ,T  K   PVt ,T  Div 

If the above inequality is violated, this does not tell us
that we will exercise, only that we cannot rule it out.
If dividends do make early exercise rational, it will be
optimal to exercise at the last moment before the ex-
dividend date.
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 Properties of Option Prices
(cont’d)
Early exercise for puts (non-dividend paying
stock)
The put will never be exercised as long as P > K – S.
Supposing that the stock pays no dividends, parity for
the put is
PSt , K , T  t   C St , K , T  t   St  PVt ,T K 

The no-exercise condition, P > K – S, then implies

C St , K , T  t   St  PVt ,T K   K  S t
C St , K , T  t   K  PVt ,T K 

If the call is sufficiently valueless, parity cannot rule

out early exercise.
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 Properties of Option Prices
(cont’d)
Early exercise for puts (dividend paying stock)
When the stock pays discrete dividend, the no-exercise
condition, P > K – S, will be modified as
C  St , K , T  t   St  PVt ,T  K   PVt ,T  div   K  St
C  St , K , T  t   K  PVt ,T  K   PVt ,T  div 
So, the stock dividends make American put harder to
exercise earlier.

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 Properties of Option Prices
(cont’d)

• Time to Expiration
– An American option (both put and call) with more time to
expiration is at least as valuable as an American option
with less time to expiration. This is because the longer
option can easily be converted into the shorter option by
exercising it early.
– A European call option on a non-dividend paying stock will
be at least as valuable as an otherwise identical option with
a shorter time to expiration. This is because a European
call on a non-dividend paying stock has the same price as
an otherwise identical American call.
– European call and put options on dividend paying stock
may be less valuable or more valuable than an otherwise
identical option with less time to expiration.

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 Properties of Option Prices
(cont’d)
• Different strike prices (K1 < K2 < K3), for both
European and American options
– A call with a low strike price is at least as valuable as an
otherwise identical call with a higher strike price:
C(K1 )  C(K 2 )
– A put with a high strike price is at least as valuable as an
otherwise identical call with a low strike price :
P(K 2 )  P(K1 )

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 Properties of Option Prices
(cont’d)
– The premium difference between otherwise identical calls
with different strike prices cannot be greater than the
difference in strike prices:
C(K1 )  C(K 2 )  K 2  K1

If the calls are European calls, we can put a tighter

restriction on the difference in call premiums, namely,

C ( K1 )  C ( K 2 )  PV  K 2  K1 

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 Properties of Option Prices
(cont’d)
– The premium difference for otherwise identical puts also
cannot be greater than the difference in strike price:

P  K 2   P  K1   K 2  K1
If the puts are European puts, we can put a tighter
restriction on the difference in put premiums, namely,

P  K 2   P  K1   PV  K 2  K1 

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 Properties of Option Prices
(cont’d)
– Premiums decline at a decreasing rate for calls with
progressively higher strike prices. The same is true for puts
as strike prices decline (Convexity of option price with
respect to strike price):

C K1   C K 2  C K 2   C K 3 

K 2  K1 K3  K 2

P  K 2   P  K1  P  K 3   P  K 2 

K 2  K1 K3  K 2

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 Properties of Option Prices
(cont’d)
Example
Suppose we observe the call premium in Panel A of Table 9.6.
These values violate the property that the premium difference
cannot be greater than the difference of the strike prices. In this
case, the arbitrage profit can be created.

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 Properties of Option Prices
(cont’d)

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 Properties of Option Prices
(cont’d)
• Exercise and Moneyness
– If it is optimal to exercise an option, it is also optimal to
exercise an otherwise identical option that is more in-the-
money.
Example
Suppose a call option on a dividend paying stock has a strike
price of $50, and the stock price is $70.
Also suppose that it is optimal to exercise the option. The option
must sell for $70 – $50 = $20.
What can we say about the premium of a 40-strike option?

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 Properties of Option Prices
(cont’d)
Since
C  40   C  50   50  40
C  40   C  50   50  40  30
the 40-strike call is optimal to exercise.

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