The Relationship Between Forward and Option Contracts

The Relationship Between Forward and Option Contracts - The...

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Unformatted text preview: The Relationship Between Forward and Option Contracts Put-Call-Spot Parity • – – – – Suppose that at Date 0, an investor forms the following portfolio involving three securities related to Company WYZ: Buy a WYZ common stock at price of S0 Purchase a put option for P0, T to deliver WYZ stock at an exercise price of X on expiration date, T Sell a call option for C0, T to purchase WYZ stock at an exercise price of X on expiration 20-1 date, T Exhibit 20.16 20-2 • The Relationship Between Forward and Option The Implication of Put-Call-Spot Parity Contracts – – – The net investment required to acquire this portfolio is (S0 + P0,T – C0,T) The net positive at expiration date no matter at what level the stock price is would + Pthe same, X X be − C = S0 0 ,T 0 ,T T (1+ RFR) The result is a risk-free investment 20-3 • Creating Synthetic Securities Using Put-Call Risk-free portfolio could be created Parity using three risky securities: – – a put option, – • stock, and a call option With Treasury-bill as the fourth security, any one of the four may be replaced with combinations of the other three 20-4 Adjusting Put-Call Spot Parity For Dividends • • The owners of derivative instruments do not participate directly in payment of dividends to holders of the underlying stock If the dividend amounts and payment dates are known when puts and calls are written those are adjusted into the option prices (long stock) + (long put) + (short call) 20-dividends) = (long T-bill) + (long present value of 5 Put-Call-Forward Parity • • • • Instead of buying stock, take a long position in a forward contract to buy stock Supplement this transaction by purchasing a put option and selling a call option, each with the same exercise price and expiration date This reduces the net initial investment vs. buying the stock in the spot market The difference between put and call 20-6 ...
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The Relationship Between Forward and Option Contracts - The...

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