Chapter 9.

No-Arbitrage Restrictions
on Option Prices

Rangarajan K. Sundaram

Stern School of Business

New York University

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Outline

Introduction

Bounds on Option Prices

The Insurance Value of an Option

Option Prices and the Strike

Option Prices and Maturity

Summary

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The Objective: Model-Independent Restrictions

I Volatility is a major source of option value.

I This means we cannot “price” options without modelling volatility.
I However, modeling volatility introduces model-risk. So: What can we say
about option values that is model-independent?
I It turns out there is quite a lot:
I Bounds on option prices.
I Behavior of option prices as the strike price increases.
I Behavior of option prices as maturity increases.
I The importance of early exercise.
I Put-Call Parity.
I This segment examines the first three items on the list; Chapter 10
examines the other two.

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Motivating Example I

I You are given the following information:

I A stock is trading at S = 55.
I There is a call option on the stock with the following features:
I The call is European in style.
I It has a maturity of 2 months.
I It has a strike of K = 50
I The call is trading at C = 3.
I A divident of D = 2 is expected on the stock in one month.
I The term-structure is flat at 12%.
I Is there an arbitrage?
I Not obvious, since the option is European, not American.

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Motivating Example II

I You are given the following information:

I A stock is trading at S = 45.
I There is a put option on the stock with the following features:
I The put is European in style.
I It has a maturity of 2 months.
I It has a strike of K = 50.
I The put is trading at P = 3.
I A dividend of D = 1 is expected on the stock in one month.
I The term-structure is flat at 12%.
I Is there an arbitrage?
I Again, not obvious, since the option is European, not American.

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Motivating Example III

I You are given the following information:

I A stock is trading at S = 100.
I There is a call option on the stock with the following features:
I The call is American in style.
I It has three months to maturity.
I It has a strike of K = 95.
I The call is trading at C = 6.
I No dividends are expected on the stock over the 3 months.
I The term-structure is flat at 12%.
I Is there an arbitrage?
I Not obvious: The option is American but is trading above the value
of immediate exercise.

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The Answers are . . .

I . . . in each case, yes: The results we develop in this segment will show
that in each of the three examples, there is a simple arbitrage opportunity.
I We revisit the examples after developing the results.

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Preliminary Considerations

I Option price bounds depend on several factors:

I Call or put?
I American or European?
I Dividends?
I Important because options are not “payout protected.”
I Dividends reduce prices, so benefit puts and hurt calls.
I We distinguish between two cases:
I Non-Dividend-Paying or NDP underlying: One which pays no
dividends during the life of the option.
I Dividend-Paying or DP underlying: One which pays dividends at
some point during the option’s life.

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Notation

I Option features:
I K : strike price of option.
I T : maturity date of option.
I Underlying:
I S: current price of underlying.
I ST : (currently unknown) price of underlying on date T .
I Option Prices:
I CA , PA : American call and put, respectively.
I CE , PE : European call and put, respectively.
I If a property holds for both American and European options, we
simply write C or P.
I PV (K ): present value of an amount K receivable at T .

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Regarding Dividends . . .

I When there are dividends, we assume that timing and size of dividend
payments are known.
I PV (D) will denote the present value (viewed from today) of the dividends
receivable over the life of the option.
I For notational simplicity, we assume a single dividend payment.
I Size: D. Timing: TD < T .
I It is an easy matter to extend the derivations to the case of multiple
dividend payments.

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A Useful Observation

I An American option can always be held to maturity.

I Therefore, an American option must cost at least as much as its European
counterpart:

CA ≥ CE

PA ≥ PE .

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Outline

Introduction

Bounds on Option Prices

The Insurance Value of an Option

Option Prices and the Strike

Option Prices and Maturity

Summary

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Upper Bound on Call Prices

I We identify bounds on call prices first.

I Upper-bound: Price of call must be less than current price of underlying:

C ≤ S.
I Why pay more than S for the right to buy the underlying asset by making
a further payment of K ?

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Two Lower Bounds on Call Prices

I We derive three separate lower bounds.

I First, a call confers a right without an obligation, so its price cannot be
negative:

C ≥ 0.
I The second bound applies to American calls.
I Such a call can be exercised at any time.
I The value of immediate exercise is (S − K ).
I Therefore, the call must cost at least (S − K ):
CA ≥ (S − K ).

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A Third Lower Bound: The Steps

I The third lower bound is a little trickier.

I We proceed in several steps:
I First: European call on a NDP asset.
I Then: European call on a DP asset.
I Finally: American calls.

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A Portfolio Comparison

I Consider a European call on an NDP underlying.

I Consider the following two portfolios:
I Portfolio A: Long one call option.
I Portfolio B: Long 1 unit of underlying; borrow PV (K ) for repayment
at T .
I Initial costs:
I Portfolio A: CE .
I Portfolio B: S − PV (K ).

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Portfolio Values at T

I Values of the portfolios at time T :

ST < K ST ≥ K

Portfolio A 0 ST − K
Portfolio B ST − K ST − K

I The figure on the next page represents these payoffs in a graph.

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The Portfolio Payoffs

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The Third Lower Bound

I Portfolios A and B have the same performance if ST ≥ K .

I Portfolio A does strictly better if ST < K .
I Neither portfolio involves any interim cash flows.
I Therefore, Portfolio A must cost at least as much as Portfolio B:

CE ≥ S − PV (K ).
I This is the third lower bound.

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What is Portfolio B?

I Suppose we had a long forward contract on this stock with

I Delivery price of K
I Maturity date of T
I At time T , we pay K and receive a stock worth ST , for a net payoff of
ST − K .
I This is exactly the same as the cash flow from Portfolio B!
I That is, Portfolio B is simply a synthetic long forward position in the
stock with a delivery price of K .
I The cost of Portfolio B is the current value of the forward contract.

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The Third Lower Bound Interpreted

I Now, the third lower bound C ≥ S − PV (K ) is easy to interpret.

I The left-hand side is the value of an option that gives us the right to buy
the underlying stock at a price of K .
I The right-hand side is the value of a forward contract that gives us the
obligation to buy the stock at the price of K .
I The right must be worth more than the obligation, hence the inequality.

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Extending the Third Lower Bound

I Extension to DP underlyings?
I If the stock pays dividends, there is an intermediate cash inflow in
Portfolio B at the time of the dividend, but there is no corresponding cash
flow in Portfolio A.
I So we create an interim cash outflow in B that eliminates this cash inflow
and restores comparability. Consider:
I Portfolio A: Long one call option.
I Portfolio B: Long one unit of underlying, borrowing of PV (K ) for
repayment at T , borrowing of PV (D) for repayment on the dividend
date.
I Initial costs:
I Portfolio A: CE
I Portfolio B: S − PV (K ) − PV (D)

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The Third Lower Bound with Dividends

I By construction, neither portfolio involves interim cash flows.

I The payoffs at T are exactly those derived earlier:
I The portfolios do identically if ST ≥ K .
I Portfolio A does strictly better if ST < K .
I So Portfolio A must cost at least as much as Portfolio B:

CE ≥ S − PV (K ) − PV (D).
I This is the third lower bound extended to dividends.

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The Third Lower Bound and Early Exercise

I Extension to early exercise?

I This is trivial:
I We must always have CA ≥ CE .
I We have just shown that
CE ≥ S − PV (K ) − PV (D).
I Therefore, we must also have
CA ≥ S − PV (K ) − PV (D).
I Summing up, the third bound holds for both American and European calls
and we simply write

C ≥ S − PV (K ) − PV (D).

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Bounds on Call Prices: Summary

I Upper-bound: C ≤ S.
I Lower-bounds for European calls:
I CE ≥ 0.
I CE ≥ S − PV (K ) − PV (D).
I Lower-bounds for American calls:
I CA ≥ 0
I CA ≥ S − K
I CA ≥ S − PV (K ) − PV (D)

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Call Pricing Bounds: Summary for D = 0

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Bounds on Put Prices

I Upper bound on put prices?

I Two simple lower bounds:
Lower Bound 1 P ≥ 0.
Lower Bound 2 PA ≥ K − S.
I A third lower bound:

P ≥ PV (K ) + PV (D) − S.

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Deriving the Third Lower Bound

I Compare:
Portfolio C Long one put with strike K and maturity T .
Portfolio D Short one unit of underlying
Investment of PV (K ) for maturity at T
Investment of PV (D) for maturity at TD .
I Initial costs:
I Portfolio C: P
I Portfolio D: PV (K ) + PV (D) − S

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Deriving the Third Lower Bound

I Interim cash flows from both portfolios are zero.

I On date T :

ST < K ST ≥ K

Portfolio A K − ST 0
Portfolio B K − ST K − ST

I It follows that P ≥ PV (K ) + PV (D) − S.

I The interpretations:
I Portfolio C: Right to sell.
I Portfolio D: Obligation to sell.

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Bounds on Put Prices: Summary

I Upper-bound: P ≤ K .
I Lower-bounds for European puts:
I PE ≥ 0.
I PE ≥ PV (K ) + PV (D) − S.
I Lower-bounds for American puts:
I PA ≥ 0
I PA ≥ K − S
I PA ≥ PV (K ) + PV (D) − S

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Put Pricing Bounds: Summary for D = 0

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Motivating Examples Revisited: Example I

I We are given:
I S = 55.
I K = 50.
I T = 1/6.
I D = 2 in one month.
I r = 0.12.
I European call with C = 3.
I Is there an arbitrage?

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Example I: The Arbitrage-Bound Violation

I Clearly C ≥ 0.
I Is C ≥ S − PV (K ) − PV (D)?
I We have PV (K ) = 49.01 and PV (D) = 1.98.
I So S − PV (K ) − PV (D) = 4.01, and the arbitrage bound is violated.
I This tells us the call is undervalued. We should buy the left-hand side and
sell the right-hand side:
I Buy the call.
I Short the stock.
I Invest PV (D) for one month.
I Invest PV (K ) for two months.

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The Arbitrage in Example I

I Initial cash flow: −3 + 55 − 49.01 − 1.98 = +1.01.

I After one month:
I Receive $2 from the investment of PV (D).
I Pay $2 dividend due on the shorted stock.
I After two months:
I If ST < 50: Let the call lapse, buy the stock for ST , and receive
K = 50 from the two-month investment. Net cash flow:
50 − ST > 0.
I If ST ≥ 50: Exercise call, buy the stock for 50, receive K = 50 from
the investment. Net cash flow: 0.
I This is the desired arbitrage.

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Example II Revisited

I We are given the following data:

I S = 45.
I K = 50.
I T = 1/6.
I D = 1 in one month.
I r = 0.12 for all maturities.
I European put with P = 3.
I Is there an arbitrage?

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Example II: The Arbitrage-Bound Violation

I Obviously P ≥ 0.
I Is P ≥ PV (K ) + PV (D) − S?
I We have PV (K ) = 49.01 and PV (D) = 0.99.
I So PV (K ) + PV (D) − S = 5.00, and the inequality is violated.
I The put is undervalued. To take advantage, we must
I Buy the put.
I Buy the stock.
I Borrow PV (D) for one month.
I Borrow PV (K ) for two months.

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The Arbitrage in Example 2

I Initial cash flow: −3 − 45 + 49.01 + 0.99 = +2.00.

I After one month: pay $1 to repay borrowing of PV (D), and receive $1 in
dividend.
I After 2 months:
I If ST < 50: Exercise the put, sell the stock for 50, and repay K on
the borrowing. Net cash flow: 50 − K = 0.
I If ST ≥ 50: Let the put lapse, sell the stock for ST , and repay K on
the borrowing. Net cash flow: ST − 50 ≥ 0.
I Since all cash flows are positive or zero, this is an arbitrage.

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Example III Revisted

I We are given the following data:

I S = 100
I T = 1/4
I K = 95
I r = 0.12
I American call with C = 6
I D = 0.
I Is there an arbitrage?

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Example III: The Arbitrage-Bound Violation

I Clearly, CA ≥ 0 and CA ≥ S − K .
I Is CA ≥ S − PV (K )?
I PV (K ) = 92.20 ⇒ S − PV (K ) = 7.80.
I Since C = 6, the third bound is violated.
I The call is undervalued, so
I Buy the call.
I Short the stock.
I Invest PV (K ).

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Example III: The Arbitrage Profits

I Initial cash inflow: −6 + 100 − 92.20 = +1.80.

I Cash flows at time T :
I If ST < 95: Let the call lapse, buy the stock at ST , and receive K
from the investment. Net cash flow: −ST + 95 > 0.
I If ST ≥ 95: Exercise call and buy the stock for K = 95, and receive
K from the investment. Net cash flow: −95 + 95 = 0.
I Thus, the strategy has no cash outflows and positive cash inflows.

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Outline

Introduction

Bounds on Option Prices

The Insurance Value of an Option

Option Prices and the Strike

Option Prices and Maturity

Summary

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Insurance Value

I An option provides protection against unfavorable price movements.

I The option’s insurance value measures the value of this protection.
I Question: How do we identify the portion of option’s value attributable to
insurance value?

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“Insurance” Provided by the Call

I Consider Portfolios A and B again. The only difference between the

portfolios is at T .
I If ST ≥ K , the two portfolios have identical payoffs.
I But if ST < K :
I Portfolio A has a value of 0 (the option is not exercised).
I Portfolio B has a negative value of (ST − K ).
I That is, Portfolio A is protected against a fall in the asset price below K ,
while Portfolio B is not.
I This is precisely the insurance provided by the call.

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Measuring the Insurance Value

I The value of this protection—the “insurance value” of the call, denoted

IV (C )—is therefore the difference in the costs of the two portfolios.

IV (C ) = C − [S − PV (K ) − PV (D)].
I Analogously, the insurance value of a put is defined by

IV (P) = P − [PV (K ) + PV (D) − S].

I For American options, the insurance value includes not only the insurance
value of the corresponding European option, but also the early exercise
premium.
I In the segment on early exercise, we make use of these definitions to
identify when and under what conditions early exercise is important.

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Outline

Introduction

Bounds on Option Prices

The Insurance Value of an Option

Option Prices and the Strike

Option Prices and Maturity

Summary

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Option Prices and the Strike

I Ceteris paribus, as the strike price increases, call values must decline and
put values must rise:

K1 < K2 =⇒ C (K1 ) ≥ C (K2 ) and P(K1 ) ≤ P(K2 )

I Intuition?
I The right to buy at K1 must be worth more than the right to buy at
the higher price K2 .
I Conversely, the right to sell at K1 must be worth less than the right
to sell at the higher price K2 .
I Two questions:
I How large can the difference be?
I How does the difference behave as the strike price increases?

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Option Prices and the Strike

I How large can the difference in option prices be?

I The maximum gain from buying a K1 -strike call rather than a K2 -strike
call is K2 − K1 .
I For European calls, even this difference can be realized only at
maturity, so
CE (K1 ) − CE (K2 ) ≤ PV (K2 − K1 )
I For American options, the difference may be realized at any time, so
CA (K1 ) − CA (K2 ) ≤ K2 − K1
I Similarly for puts, we have

PE (K2 ) − PE (K1 ) ≤ PV (K2 − K1 )

PA (K2 ) − PA (K1 ) ≤ K2 − K1 .

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Option Prices and the Strike

I Consider any three strike prices K1 < K2 < K3 . Define

K3 − K2
w =
K3 − K1
I Then, we must have

wC (K1 ) + (1 − w )C (K3 ) ≥ C (K2 )

wP(K1 ) + (1 − w )P(K3 ) ≥ P(K2 )

I This is convexity of option prices in the strike price; if this property did
not hold, we could construct a butterfly spread “for free.”
I In particular, if the strikes are equally spaced, we have

C (K1 ) − C (K2 ) ≥ C (K2 ) − C (K3 ),

that is, the difference in call values narrows as strikes increase.

I What is the corresponding property for puts?

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Outline

Introduction

Bounds on Option Prices

The Insurance Value of an Option

Option Prices and the Strike

Option Prices and Maturity

Summary

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Option Prices and Time to Maturity

I How do option prices behave as maturity lengthens?

I For American options, more time to maturity is always a good thing—we
can always exercise early if we don’t want the extra time. So

T1 < T2 =⇒ CA (T1 ) ≤ CA (T2 ), PA (T1 ) ≤ PA (T2 )

I Does this hold for European options?
I Yes, for European calls on NDP stock.
I Possibly not for European puts even on NDP stock.

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European Calls and Time to Maturity

I Consider European calls on NDP stock.

I At time T1 , the T1 -maturity call is at maturity, so is worth

max{ST1 − K , 0}
I At time T1 , by the no-abitrage conditions derived earlier, the T2 -maturity
call is worth at least

max{0, ST1 − PV (K )}

where PV (K ) is the value at T1 of an amount K receivable at T2 .

I The T2 -call is worth at least as much as the T1 -call at time T1 , so it must
be worth at least as much at earlier times also:

CE (T1 ) ≤ CE (T2 )
I What happens if there are dividends between T1 and T2 ?

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European Puts and Time to Maturity

I For European puts, an increase in time-to-maturity cannot always be a

good thing.
I Why? Upper bound on T -maturity European put’s value:

PE (T ) ≤ PV (K )

where PV (K ) is the value of K receivable at time T .

I What is this upper bound if T = ∞?
I If European put values did, in fact, increase with T , we would have

PE (T ) ≤ PE (∞).

What would this imply concerning put prices?

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Outline

Introduction

Bounds on Option Prices

The Insurance Value of an Option

Option Prices and the Strike

Option Prices and Maturity

Summary

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Summary

I This segment has provided three sets of restrictions on option prices based
on no-arbitrage considerations alone:
1. Upper and lower bounds on option prices.
2. The behavior of option prices as the strike price increases.
3. The behavior of option prices as time to maturity increases.
I We have also provided an intuitive definition of the insurance value of an
option.
I In the next segment, we will use this definition to identify the
conditions under which early exercise becomes important.

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