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lecture03post - Put-call parity Other static trades Lecture...

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Unformatted text preview: Put-call parity Other static trades Lecture 3 - Static option trades BUSI 588, Fall 2011 Diego Garc a Kenan-Flagler Business School UNC at Chapel Hill August 31st, 2011 c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 3 - Static option trades 1 / 25 Put-call parity Other static trades Outline and handouts 1 Put-call parity Rocinante Put-call parity 2 Other static trades Option price bounds Early exercise of American options Handouts today: Class slides. Case 3 solutions. c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 3 - Static option trades 2 / 25 Put-call parity Other static trades An aside on dividend paying assets We will say that an asset pays a dividend yield (proportional dividend) if when we invest 1 unit of stock at date t we get S T (1 + ) T- t at date T . Think about it as reinvesting the dividends in the asset, so you end up with (1 + ) T- t units. When assets pay discrete dividends (i.e. individual stocks paying quarterly dividends), one must model option prices somewhat differently. Options are typically not dividend protected, i.e. if the underlying asset price goes down so will the (expected) payoffs from a call. But exchanges have some discretion (i.e. CBOE and Gucci). c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 3 - Static option trades 3 / 25 Put-call parity Other static trades Frictionless trading For the most part we will start thinking about a world where trading is frictionless : No transaction costs. No bid-ask spreads. We can trade as much as we want without moving prices. We can both buy and sell any security we want. Keep in mind: This is a good approximation to reality, but only an approximation. It may be a bad approximation in some cases. Some underlying assets we cant trade (individual mortgages, weather). It is a first step, much research effort devoted to transaction costs/liquidity issues. c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 3 - Static option trades 4 / 25 Put-call parity Other static trades Trading strategies Arbitrage arguments are all about trading. Definition A trading strategy is a collection of instructions that specifies how much of each security to hold in a portfolio at each possible point in time, given what has happened in the past. A few things to note: We may decide to change our trading strategy through time (dynamic trading vs static trading). We shall assume that we can buy and sell at given market prices. Cash-flows associated with (short) sales are simply the opposite (negative) of the cash-flows associated with buying a security. c Diego Garc a, BUSI 588, Kenan-Flagler, Fall 2011 Lecture 3 - Static option trades 5 / 25 Put-call parity Other static trades Arbitrage Definition We will say that there is an arbitrage opportunity in a financial market if one can construct a trading strategy such that either The cash flow today, t = 0, is positive; and the cash flows in the future ( t = 1 ,..., T ) are non-negative (could be zero).) are non-negative (could be zero)....
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This note was uploaded on 11/25/2011 for the course BUSI 588 taught by Professor Staff during the Fall '10 term at UNC.

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lecture03post - Put-call parity Other static trades Lecture...

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