Exercises with Option Bounds

Problem: Option Bounds without Dividends

• A 1-month European put option on a non-dividend paying stock is

currently selling for $2.50. The stock price is $47, the strike price is
$50, and the (continuously compounded) risk-free interest rate is 6%
per annum.

• Q: What opportunities are there for an arbitrageur?

• Put is underpriced at 2.5, which is below lower bound:

Ke-rT-S0=50e-6%*1/12-47=2.75

• Arbitrage strategy:
Today T, ifST ≤ K T, if ST > K
long p, short Ke-rT, long S0 50-ST-50+ST 0-50+ST
-2.50+2.75=0.25 0 >0
Problem: Option Bounds with Dividends

• A 4-month European call option on a dividend-paying stock is

currently selling for $8. The otherwise identical put is selling for $3.
The stock price is $64, the strike price is $60, and a dividend of
$0.80 is expected in 1 month. The risk-free interest rate is 12% per
annum for all maturities.

• Q: What opportunities are there for an arbitrageur?

• PCP: p = 8 + 60 e-12%*4/12 - 64 + 0.8 e-12%*1/12 =2.44, thus overpriced!

Today ST ≤ K ST > K
Long: c, PV(D), K e-rT, 0+FV(D)+60-ST -(60-ST)-FV(D) ST-60+FV(D)+60-ST
Short: S0, p -FV(D)-0
-8-0.79-57.65+64+3=$0.56 0 0
Application (1/2)
• Consider the following data on SPY option prices:

Data from Apr.2. 2014, about 11.15am

SPOT SPY 188.71

Call Options Expire at close Friday, April 25, 2014

Strike Symbol Last Chg Bid Ask Vol Open Int
180 SPY140425C00180000 7.55 0 8.97 9.08 7 709
185 SPY140425C00185000 4.7 0.32 4.57 4.64 112 1,857
190 SPY140425C00190000 1.31 0.11 1.29 1.31 1,350 20,291
195 SPY140425C00195000 0.14 0.01 0.13 0.14 26 479

Put Options Expire at close Friday, April 25, 2014

Strike Symbol Last Chg Bid Ask Vol Open Int
180 SPY140425P00180000 0.33 0.05 0.31 0.34 380 8,436
185 SPY140425P00185000 0.9 0.17 0.9 0.92 194 5,019
190 SPY140425P00190000 2.53 0.54 2.59 2.62 112 515
195 SPY140425P00195000 8 0 6.37 6.5 4 158
Application (2/2)

• Q1: Discuss the patterns of open interest for call and put options on
the SPY ETF
• Little liquidity far out of the Money (really low open interest, i.e
number of contracts open)

• Q2: Do option prices verify no-arbitrage lower and upper bounds?

What about put-call parity?
• Assume no dividends and short-term rate r=0 in April 2014
• Prices (average of bid and ask) satisfy these bounds tightly
• lower bound 180 call=188.71-180 = 8.71< (8.97+9.08)/2 =9.025

• Difference between c + K e-rT and p + S0 is well-within bounds

defined by bid vs ask prices!
• for 180 call and put:
[(8.97+9.08)/2+180] – [(0.31+0.34)/2+188.71]=0.01 < bid-ask
spread of both put and call
A 6-month European call option on a dividend-paying stock is
currently selling for $9. The stock price is $70, the strike price
is $68, and a dividend of $2 is expected in 2 month. The
continuously compounded risk-free interest rate is 10% per
year for all maturities.
1. What is the lower bound of the call? Is it respected?
2. Calculate the no-arbitrage price of the identical put option
3. The identical put option is trading in the market at 8$. Is
there an arbitrage opportunity? If yes, explain only what
you have to buy and sell/short to start the strategy