Risk Management Basics
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- Put-Call Parity
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Put-Call Parity – As the name suggests, put-call parity establishes a relationship between put options and call options price.
It is defined as a relationship between the prices of a European put options and calls options having same strike prices, expiry and underlying or we can define it as an equivalence relationship between the Put and Call options of a common underlying carrying the same strike price and expiry.
In this article, we look at the concept of Put Call Parity in detail –
- Put Call Parity Theorem
- Call Options and Put Options
- Important Terminologies in Options
- Put-Call Parity Example
- Arbitrage Opportunity through Put-Call Parity
- The Other side of Put-Call parity
- Determining Call options & Put options premium
- Impact of dividends on put-call parity
- Concluding Remarks
Put Call Parity Theorem
The theory was first identified by Hans Stoll in 1969.
Put-Call parity theorem says that premium (price) of a call options implies a certain fair price for corresponding put options provided the put options has the same strike price, underlying and expiry and vice versa. It also shows the three sided relationship between a call, a put and an underlying security.
Call Options and Put Options
Before going further into in-depth study of put-call parity, first get an insight view of certain terminologies and definitions related to options.
- Call Option: Call option is a derivative contract which gives owner the right but not the obligation to buy an underlying asset at a predetermined price (strike price) and time till expiration of the contract. The call options is generally exercised by holder only if the stock price is more than the strike price or the options is in the money (ITM). It is logical not to exercise if the option is out of the money (OTM). And hence, the pay-off for call option is max(ST-X,0).
- Put Option: Put option gives owner the right but not the obligation to sell an underlying asset at a predetermined price and time till expiration of the contract. The put options is generally exercised by holder only if the stock price is less than the strike price. And hence, the pay-off for put option is max(X- ST,0).
Important Terminologies in Options
S0 = Stock price today,
X = Strike price
C0 = European call option premium
P0 = European put option premium
T = Time to expiration
r = Risk free rate of return
Let’s back at our prime topic now.
Put-Call Parity Example
The above mentioned theorem can be elaborated with the below example.
Let’s take a look at two portfolios of an investor:
Portfolio A: A European call options for a strike price of $500/- which has a premium or price of $80/- and pays no dividend (impact of dividend is discussed later in the paper) and A zero coupon bond (which pays only principal at the time of maturity) which pays Rs.500/- (or the strike price of call options) at maturity and,
Portfolio B: Underlying stock on which call options is written and a European put options having identical strike price of $500/- which has a premium of $80/- and an identical expiry.
In order to calculate pay-offs from both the portfolios, let’s consider two scenarios:
- Stock price goes up and closes at $600/- at the time of maturity of options contract,
- Stock price has fallen and closes at $400/- at the time of maturity of options contract.
Impact on Portfolio A in Scenario 1: Portfolio A will be worth the zero coupon bond i.e.$500/- plus $100/- from call options pay-off i.e. max(ST-X,0). Therefore, portfolio A will be worth the stock price (ST) at time T.
Impact on Portfolio A in Scenario 2: Portfolio A will be worth the share price i.e. $500/- since the stock price is less than the strike price (it is out of the money), the options will not be exercised. Hence, portfolio A will be worth stock price (ST) at time T.
Likewise, for portfolio B, we will analyze the impact with both the scenarios.
Impact on Portfolio B in Scenario 1: Portfolio B will be worth the stock price or share price i.e. $600/- since the share price is lower than the strike price (X) and are worthless to exercise. Therefore, portfolio B will be worth the stock price (ST) at time T.
Impact on Portfolio B in Scenario 2: Portfolio B will be worth the difference between strike price and stock price i.e. $100/- and underlying share price i.e. $400/-. Hence, portfolio B will be worth strike price (X) at time T.
The above pay-offs are summarized below in Table 1.
|When, ST > X||When, ST < X|
|Portfolio A||Zero Coupon bond||500||500|
|Portfolio B||Underlying Stock (Share)||600||400|
*The pay-off of an call option = max(ST-X,0)
#The pay-off of a put option = max(X- ST,0)
In the above table we can summarize our findings that when stock price is more than the strike price (X), the portfolios are worth the stock or share price (ST) and when the stock price is lower than the strike price, the portfolios are worth the strike price (X). In other words, both the portfolios are worth max(ST, X).
Portfolio A: When, ST > X, it is worth ST,
Portfolio B: When, ST < X, it is worth X
Since, both the portfolios have identical values at time T, they must therefore have similar or identical values today (since the options are European, it cannot be exercised prior to time T). And if this is not true an arbitrageur would exploit this arbitrage opportunity by buying the cheaper portfolio and selling the costlier one and book an arbitrage (risk free) profit.
This brings us to a conclusion that today portfolio A should be equal to Portfolio B. or,
C0+X*e-r*t = P0+S0
Arbitrage Opportunity through Put-Call Parity
Let’s take an example to understand the arbitrage opportunity through put-call parity.
Suppose, share price of a company is $80/-, the strike price is $100/-, the premium (price) of a six month call option is $5/- and that of a put option is $3.5/-. The risk free rate in the economy is 8% per annum.
Now, as per the above equation of put-call parity, value of the combination of call option price and the present value of strike would be,
C0+X*e-r*t = 5+100*e-0.08*0.5
And value of the combination of put option and share price is
P0+S0 = 3.5+80
Here, we can see that first portfolio is overpriced and can be sold (an arbitrageur can create a short position in this portfolio) and second portfolio is relatively cheaper and can be bought (arbitrageur can create a long position) by the investor in order to exploit arbitrage opportunity.
This arbitrage opportunity involves buying a put option and a share of the company and selling a call option.
Let’s take this further, by shorting the call option and creating a long position in put option along with share would require below calculated funds to be borrowed by an arbitrageur at risk free rate i.e.
Hence, an amount of $78.5 would be borrowed by the arbitrageur and after six months this needs to be repaid. Hence, the repayment amount would be
Also, after six months either the put or call option would be in the money and will be exercised and arbitrageur would get $100/- from this. The short call and long call put option position would therefore leads to the stock being sold for $100/-. Hence, the net profit generated by the arbitrageur is
= 100 – 81.70
The above cash flows are summarized in the Table 2:
|Steps involved in arbitrage position||Cost involved|
|Borrow $78.5 for six months and create a position by selling one call option for $5/- and buying one put option for $3.5/- along with a share for $80/-
|After six months, if share price is more than the strike price, call option would be exercised and if it is below strike price then put option would be exercised||100|
|Net Profit (+) / Net Loss (-)||18.3|
The Other side of Put-Call parity
Put-Call parity theorem only holds true for European style options as American style options can be exercised at any time prior to its expiry.
The equation which we have studied so far is
C0+X*e-r*t = P0+S0
This equation is also called as Fiduciary Call is equal to Protective Put.
Here, the left side of the equation is called Fiduciary Call because in fiduciary call strategy, an investor limits its cost associated with exercising the call option (as to fee for subsequently selling an underlying which has been physical delivered if the call is exercised).
The right side of the equation is called Protective Put because in protective put strategy an investor is purchasing put option along with a share (P0+S0). In case, share prices goes up the investor can still minimizes their financial risk by selling shares of the company and protects their portfolio and in case the share prices goes down he can close his position by exercising the put option.
Suppose strike price is $70/-, Stock price is $50/-, Premium for Put Option is $5/- and that of Call Option is $15/-. And suppose that stock price goes up to $77/-.
In this case, the investor will not exercise its put option as the same is out of the money but will sell its share at current market price (CMP) and earn the difference between CMP and initial price of stock i.e. Rs.7/-. Had the investor not been purchased sock along with the put option, he would have been end up incurring loss of his premium towards option purchase.
Determining Call options & Put options premium
We can rewrite the above equation in two different ways as mentioned below.
- P0 = C0+X*e-r*t-S and
- C0 = P0+S0-X*e-r*t
In this way, we can determine price of a call option and put option.
For example, let’s assume price of a XYZ company is trading at Rs.750/- six months call option premium is Rs.15/- for strike price of Rs.800/-. What would be the premium for put option assuming risk free rate as 10%.
As per equation mentioned above in point no 1,
P0 = C0+X*e-r*t-S
Likewise, suppose that in the above example put option premium is given as $50 instead of call option premium and we have to determine call option premium.
C0 = P0+S0-X*e-r*t
Impact of dividends on put-call parity
So far in our studies, we have assumed that there is no dividend paid on the stock. Therefore, the very next thing which we have to take into consideration is impact of dividend on put-call parity.
Since interest is a cost to an investor who borrows funds to purchase stock and benefit to investor who shorts the stock or securities by investing the funds.
Here we will examine how the Put-Call parity equation would be adjusted if stock pays dividend. Also, we assume that dividend which is paid during the life of the option is known.
Here, the equation would be adjusted with the present value of dividend. And along with call option premium, the total amount to be invested by the investor is cash equivalent to present value of zero coupon bond (which is equivalent to strike price) and present value of dividend. Here, we are making adjustment in fiduciary call strategy. The adjusted equation would be
C0+(D+X*e-r*t) = P0+ S0 where,
D = Present value of dividends during the life of
Let’s adjust the equation for both the scenarios.
For example, suppose the stock pays $50/- as dividend then, adjusted put option premium would be
P0 = C0+(D+X*e-r*t) – S0
We can adjust the dividends in other way also which will yield the same value. The only basic difference between these two ways are while in first one we have added the dividends amount in strike price, in the other one we have adjusted the dividends amount directly from the stock.
P0 = C0+X*e-r*t– S0-(S0*e-r*t),
In the above formula we have deducted the dividends amount (PV of dividends) directly from the stock price. Let’s look at the calculation through this formula
- Put-Call parity establishes relationship between the prices of a European put options and calls options having same strike prices, expiry and underlying.
- Put-Call Parity does not hold true for American option as American option can be exercised at any time prior to its expiry.
- Equation for put-call parity is C0+X*e-r*t = P0+S0.
- In put-call parity, Fiduciary Call is equal to Protective Put.
- Put-Call parity equation can be used to determine the price of European call and put options
- Put-Call parity equation is adjusted, if stock pays any dividends.