MFE Lesson 1 Slides

Lesson 1: Put-Call Parity
ACTS 4302
Natalia A. Humphreys
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Acknowledgement
This work is based on the material in ASM MFE Study manual for
Exam MFE/Exam 3F. Financial Economics (7th Edition), 2009, by
Abraham Weishaus.
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Put - Call parity (PCP)
Put - Call parity gives a relationship between the premium of a call

and the premium of a put.
For now, well consider only the European options.
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PCP - Derivation
Suppose we bought a European call option and sold a European

put option, both having the same underlying asset St , the same
strike K , and the same time to expiry T . We would then pay
C (K , T ) P(K , T )
BUT: The result can be achieved without using options at all!
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PCP - Derivation
At time T one of the options will be exercised. In either case, we

pay K and receive the underlying asset:
I
If ST > K , exercise the call option that we bought. Pay K

and receive the asset.
If ST < K , exercise the put option that the counterparty

bought from us. We will pay K and receive the asset.
If ST = K , it does not matter whether we have K or the

underlying asset.
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PCP - Derivation
There are two ways to receive ST at time T .
1. Buy a call option and sell a put option at time 0, and pay K at
time T .
2. Enter a forward agreement to buy ST , and at time T pay F0,T ,
the price of forward.
By the principle of no arbitrage, the two ways must cost the
same. Discounting to time 0, we have:
C (K , T ) P(K , T ) + Ke rT = F0,T e rT
Or
C (K , T ) P(K , T ) = F0,T e rT Ke rT
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PCP - Non-dividend paying stock
Recall that for non-dividend paying stock F0,T = S0 e rT . Thus, the

PCP becomes
C (K , T ) P(K , T ) = S0 Ke rT
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PCP - Non-dividend paying stock - Example 1.1
A non-dividend paying stock has a price of 40. A European call

option allows buying the stock for 45 at the end of 9 months. The
continuously compounded risk-free rate is 5%. The premium of the
call option is 2.84.
Determine the premium of a European put option allowing selling
the stock for 45 at the end of 9 months.
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PCP - Non-dividend paying stock - Example 1.1 - Solution
Solution. In this problem

S0 = 40, K = 45, C (K , T ) = 2.84, T = 0.75, r = 5%
By the PCP for non-dividend paying stock, we have:
P(K , T ) = C (K , T ) S0 + Ke rT =
= 2.84 40 + 45 e 0.050.75 = 6.1838 6.18
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PCP - Dividend paying stock with discrete dividends
Recall that for discrete dividend paying stock

F0,T = S0 e rT CumValue(Div). Thus, the PCP becomes
C (K , T ) P(K , T ) = S0 PV(Div) Ke rT
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PCP - Dividend paying stock with discrete dividends Example 1.2
A stock price is 45. The stock will pay a dividend of 1 after 2

months. A European put option with a strike of 42 and an expiry
date of 3 months has a premium of 2.71. The continuously
compounded risk-free rate is 5%.
Determine the premium of a European call option on the stock
with the same strike and expiry.
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PCP - Dividend paying stock with discrete dividends Example 1.2 - Solution
S0 = 45, K = 42, P(K , T ) = 2.71, T = 0.25, r = 5%,
1
Div = 1 at time t =
6
By the PCP for discrete-dividend paying stock, we have:
C (K , T ) = P(K , T ) + S0 PV(Div) Ke rT =
1
= 2.71 + 45 1 e 0.05 6 42 e 0.050.25 =

= 47.71 0.9917 41.4783 = 5.24
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PCP - Dividend paying stock with discrete dividends Example 1.3
A stock price is 50. The stock will pay a dividend of 2 after 4

months. A European call option with a strike of 50 and an expiry
date of 6 months has a premium of 1.62. The continuously
compounded risk-free rate is 4%.
Determine the premium of a European put option on the stock
with the same strike and expiry.
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PCP - Dividend paying stock with discrete dividends Example 1.3 - Solution
S0 = 50, K = 50, C (K , T ) = 1.62, T = 0.5, r = 4%,
1
Div = 2 at time t =
3
By the PCP for discrete-dividend paying stock, we have:
P(K , T ) = C (K , T ) S0 + PV(Div) + Ke rT =
1
= 1.62 50 + 2 e 0.04 3 + 50 e 0.040.5 =

= 48.38 + 1.9735 + 49.01 = 2.60
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PCP - Dividend paying stock with continuous dividends
Let be a dividend rate.

Recall that for continuous dividend paying stock F0,T = S0 e (r )T .
Thus, the PCP becomes
C (K , T ) P(K , T ) = S0 e T Ke rT
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PCP - Dividend paying stock with continuous dividends Example 1.4
You are given:

(i) A stocks price is 40.
(ii) The continuously compounded risk-free rate is 8%.
(iii) The stocks continuous dividend rate is 2%
A European 1-year call option with a strike of 50 costs 2.34.
Determine the premium of a European 1-year put option on the
stock with a strike of 50.
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PCP - Dividend paying stock with continuous dividends Example 1.4 - Solution
S0 = 40, K = 50, C (K , T ) = 2.34, T = 1, r = 8%,
= 2%
By the PCP for continuous-dividend paying stock, we have:
P(K , T ) = C (K , T ) S0 e T + Ke rT =
= 2.34 40 e 0.021 + 50 e 0.081 =
= 2.34 39.21 + 46.16 = 9.29
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PCP - Dividend paying stock with continuous dividends Example 1.5
You are given:

(i) A stocks price is 57.
(ii) The continuously compounded risk-free rate is 5%.
(iii) The stocks continuous dividend rate is 3%
A European 3-month put option with a strike of 55 costs 4.46.
Determine the premium of a European 3-month call option on the
stock with a strike of 55.
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PCP - Dividend paying stock with continuous dividends Example 1.5 - Solution
S0 = 57, K = 55, P(K , T ) = 4.46, T = 0.25, r = 5%,
= 3%
By the PCP for continuous-dividend paying stock, we have:
C (K , T ) = P(K , T ) + S0 e T Ke rT =
= 4.46 + 57 e 0.030.25 55 e 0.050.25 =
= 4.46 + 56.5741 54.3168 = 6.72
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Currency options - Puts and Calls notation
C (x0 , K , T ) - a call option on currency with spot exchange

rate x0 to purchase it at exchange rate K at time T
P(x0 , K , T ) - a put option on currency with spot exchange

rate x0 to sell it at exchange rate K at time T
20 / 38
Currency options - PCP

Recall:
I
General formula for a PCP

C (S, K , T ) P(S, K , T ) = (F0,T K )e rT
rf is the foreign risk-free rate for the currency which is

playing the role of a stock
rd is the domestic risk-free rate which is playing the role of

cash
Price of a forward expressed in domestic currency to deliver

foreign currency at x0 exchange rate: F0,T = x0 e (rd rf )T
Then PCP becomes:

C (x0 , K , T ) P(x0 , K , T ) = x0 e rf T Ke rd T
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Currency options - Example 1.6
You are given:

I
The spot exchange rate for dollars to pounds is 1.4$/.
The continuously compounded risk-free rate for dollars is 5%.
The continuously compounded risk-free rate for pounds is 8%.
A 9-month European put option allows selling 1 at the rate of

$1.50/. A 9-month dollar denominated call option with the same
strike costs $0.0223.
Determine the premium of the 9-month dollar denominated put
option.
22 / 38
Currency options - Example 1.6. Solution.

Solution. We are buying pounds. Thus, pounds play the role of
stock or foreign currency.
We pay for pounds with dollars. Thus, dollars play the role of cash
or domestic currency. Therefore,
rf = 0.08, rd = 0.05, x0 = 1.4, K = 1.5,
C (x0 , K , T ) = 0.0223, T = 0.75
By the PCP for currency options,
P(x0 , K , T ) = C (x0 , K , T ) x0 e rf T + Ke rd T =
= 0.0223 1.4 e 0.080.75 + 1.5 e 0.050.75 =
= 0.0223 1.3185 + 1.4448 = 0.1486
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Currency options - Example 1.7
You are given:

I
The spot exchange rate for yen to dollars is 90U/$.
The continuously compounded risk-free rate for dollars is 5%.
The continuously compounded risk-free rate for yen is 1%.
A 6-month yen-denominated European call option has a strike of

90U/$ and costs U3.25.
Determine the premium of a 6-month yen denominated European
put option having a strike of 90U/$.
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Currency options - Example 1.7. Solution.

Solution. We are buying dollars. Thus, dollars play the role of
stock or foreign currency.
We pay for pounds with yen. Thus, yen play the role of cash or
domestic currency. Therefore,
rf = 0.05, rd = 0.01, x0 = 90, K = 90,
C (x0 , K , T ) = 3.25, T = 0.5
By the PCP for currency options,
P(x0 , K , T ) = C (x0 , K , T ) x0 e rf T + Ke rd T =
= 3.25 90 e 0.050.5 + 90 e 0.010.5 =
= 3.25 87.7789 + 89.5511 = 5.0232
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Exchange options - Introduction
So far weve discussed receiving (call) or giving (put) stock in

return for cash.
GENERALIZE
An option to receive a stock in return for a different stock.
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Exchange options - Notation
St - the value of the underlying asset, the one for which the
option is written
Qt - the price of the strike asset, the one which is paid
Ft,T (S) - a forward agreement to purchase asset S at time T
P (S) - prepaid forward: F P (S) = e r (T t) F

Ft,T
t,T (S)
t,T
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Exchange options - Calls and Puts
C (St , Qt , T t) a call option written at time t which lets the

purchaser elect to receive ST in return for QT at time T , i.e.
to receive max(0, ST QT ).
P(St , Qt , T t) a put option written at time t which lets the

purchaser elect to give ST in return for QT at time T , i.e. to
receive max(0, QT ST ).
Then the Put-Call Parity is

P
P
C (St , Qt , T t) P(St , Qt , T t) = Ft,T
(St ) Ft,T
(Qt )
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Exchange options - Calls and Puts -Final expression
If
I
S is continuous dividend rate of stock S and
Q is continuous dividend rate of stock Q
Then the Put-Call Parity is

C (St , Qt , T t) P(St , Qt , T t) = St e S (T t) Qt e Q (T t)
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Exchange options - Example 1.8

A European call option allows one to purchase 2 shares of Stock B
with 1 share of stock A at the end of a year. You are given:
I
The continuously compounded risk-free rate is 5%.
Stock A pays dividends at a continuous rate of 2%.
Stock B pays dividends at a continuous rate of 4%.
The current price for Stock A is 70.
The current price for Stock B is 30.
A European put option which allows one to sell 2 shares of Stock

B for 1 share of Stock A costs 11.50.
Determine the premium of the European call option mentioned
above, which allows one to purchase 2 shares of Stock B for 1
share of Stock A.
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Exchange options - Example 1.8. Solution.

Solution. Risk-free rate in these type of problems is irrelevant. Let
us figure out what plays the role of S and what plays the role of Q
in our problem.
Since we are purchasing 2 shares of Stock B, they play the role of
stock S in the PCP for exchange options. Note S = 2 30 = 60.
Since we use 1 share of Stock A to pay for 2 shares of Stock B, it
plays the role of stock Q in the PCP for exchange options. Note
Q = 70.
Further, S = 0.04, Q = 0.02, T = 1 and
P
P
C (St , Qt , T t) = P(St , Qt , T t) + Ft,T
(S) Ft,T
(Q) =
= P(St , Qt , T t) + St e S T Qt e Q T =
= 11.50 + 60 e 0.041 70 e 0.021 =
= 11.50 + 57.6474 68.6139 = 0.5335 0.53
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Exchange options - The mirror image

The definitions of calls and puts are mirror images. A call to
purchase Q for S is the same as a put to sell S for Q:
C (Qt , St , T t) = P(St , Qt , T t)
Thus, PCP for exchange options
C (St , Qt , T t) P(St , Qt , T t)
St e S (T t) Qt e Q (T t)
C (St , Qt , T t) C (Qt , St , T t)
St e S (T t) Qt e Q (T t)
Thus, in the previous example, a call which allows one to purchase

2 shares of Stock B for 1 share of Stock A is the same as the put
that allows one to sell 1 share of Stock A for 2 shares of Stock B.
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Put-Call connection in different currency units
Let us look at currency options in light of exchange options weve

just discussed.
A call to purchase pounds with dollars
A put to sell dollars for pounds

BUT: the units are different. Let us see how to translate the units.
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Put-Call connection in different currency units

Call-Put relationship in domestic currency: If K is the strike
price and C (x0 , K , T ) is the call price in domestic currency, then

1 1
, , T = Cd (x0 , K , T )
KPd
x0 K
Ex. If x0 =$3/ and the strike price is K = $2, then a $ denominated call to buy 1 for $2 is the same as a $ denominated put to sell $2 for 1 or 2 $ denominated puts to sell
$1 for 1/2.
Call-Put relationship in foreign and domestic currency:

1 1
Kx0 Pf
, , T = Cd (x0 , K , T )
x0 K
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Put-Call connection in different currency units. Example

1.9.
The spot exchange rate for dollars into euros is $1.05/e. A

6-month dollar denominated call option to buy one euro at strike
price $1.1/e costs $0.04.
Determine the premium of the corresponding euro-denominated put
option to sell one dollar for euros at the corresponding strike price.
35 / 38

1.9. Solution.
Solution. Here the domestic currency = dollars and the foreign
currency = euros. We have:
x0 = 1.05, T = 0.5, K = 1.1, Cd (x0 , K , T ) = 0.04
Using Call-Put relationship in foreign and domestic currency:

1 1
, , T = Cd (x0 , K , T )
Kx0 Pf
x0 K

1 1
1
Pf
, ,T =
Cd (x0 , K , T )
x0 K
Kx0
we obtain:
Pf =
1
0.04 = 0.03463 0.035
1.05 1.1
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1.10.
The spot rate for yen denominated in pounds sterling is 0.005/U.

A 3-month pound-denominated put option has strike price
0.0048/U and costs 0.0002.
Determine the premium in yen for an equivalent 3-month
yen-denominated call option with a strike of U208 13 .
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1.10. Solution.
Solution. Here the domestic currency = pounds and the foreign
currency = yen. We have:
x0 = 0.005, T = 0.25, K = 0.0048, Pd (x0 , K , T ) = 0.0002
Note that 1/K = 208 31 . We need to find Cf .
Note that Call-Put relationship in foreign and domestic
currency:

1 1
1
Pf
, ,T =
Cd (x0 , K , T )
x0 K
Kx0
can be re-written as

1 1
1
Cf
, ,T =
Pd (x0 , K , T )
x0 K
Kx0
Hence,
Cf =
1
1
0.0002 = 8 8.33
0.0048 0.005
3
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Lesson 1: Put-Call Parity

Put - Call parity (PCP)

Put - Call parity gives a relationship between the premium of a call

Suppose we bought a European call option and sold a European

At time T one of the options will be exercised. In either case, we

If ST > K , exercise the call option that we bought. Pay K

If ST < K , exercise the put option that the counterparty

If ST = K , it does not matter whether we have K or the

PCP - Non-dividend paying stock

Recall that for non-dividend paying stock F0,T = S0 e rT . Thus, the

PCP - Non-dividend paying stock - Example 1.1

A non-dividend paying stock has a price of 40. A European call

PCP - Non-dividend paying stock - Example 1.1 - Solution

Solution. In this problem

PCP - Dividend paying stock with discrete dividends

Recall that for discrete dividend paying stock

PCP - Dividend paying stock with discrete dividends Example 1.2

A stock price is 45. The stock will pay a dividend of 1 after 2

= 2.71 + 45 1 e 0.05 6 42 e 0.050.25 =

PCP - Dividend paying stock with discrete dividends Example 1.3

A stock price is 50. The stock will pay a dividend of 2 after 4

= 1.62 50 + 2 e 0.04 3 + 50 e 0.040.5 =

PCP - Dividend paying stock with continuous dividends

Let be a dividend rate.

PCP - Dividend paying stock with continuous dividends Example 1.4

You are given:

PCP - Dividend paying stock with continuous dividends Example 1.5

You are given:

Currency options - Puts and Calls notation

C (x0 , K , T ) - a call option on currency with spot exchange

P(x0 , K , T ) - a put option on currency with spot exchange

Currency options - PCP

General formula for a PCP

rf is the foreign risk-free rate for the currency which is

rd is the domestic risk-free rate which is playing the role of

Price of a forward expressed in domestic currency to deliver

Then PCP becomes:

Currency options - Example 1.6

You are given:

The spot exchange rate for dollars to pounds is 1.4$/.

The continuously compounded risk-free rate for dollars is 5%.

The continuously compounded risk-free rate for pounds is 8%.

A 9-month European put option allows selling 1 at the rate of

Currency options - Example 1.6. Solution.

Currency options - Example 1.7

You are given:

The spot exchange rate for yen to dollars is 90U/$.

The continuously compounded risk-free rate for dollars is 5%.

The continuously compounded risk-free rate for yen is 1%.

A 6-month yen-denominated European call option has a strike of

Currency options - Example 1.7. Solution.

Exchange options - Introduction

So far weve discussed receiving (call) or giving (put) stock in

Exchange options - Notation

Qt - the price of the strike asset, the one which is paid

Ft,T (S) - a forward agreement to purchase asset S at time T

P (S) - prepaid forward: F P (S) = e r (T t) F

Exchange options - Calls and Puts

C (St , Qt , T t) a call option written at time t which lets the