Investment Analysis and

Portfolio Management
Lecture 10
Gareth Myles
Put-Call Parity
 The prices of puts and calls are related
 Consider the following portfolio
 Hold one unit of the underlying asset
 Hold one put option
 Sell one call option
 The value of the portfolio is
P = S + Vp – V c
 At the expiration date
P = S + max{E – S, 0} – max{S – E, 0}
Put-Call Parity
 If S < E at expiration the put is exercised so
P=S+E–S=E
 If S > E at expiration the call is exercised so
P=S–S+E=E
 Hence for all S
P=E
 This makes the portfolio riskfree so
S + Vp – Vc = (1/(1+r)t)E
Valuation of Options
 At the expiration date
Vc = max{S – E, 0}
Vp = max{E – S, 0}
 The problem is to place a value on the options
before expiration
 What is not known is the value of the
underlying at the expiration date
 This makes the value of Vc and Vp uncertain
 An arbitrage argument can be applied to value
the options
Valuation of Options
 The unknown value of S at expiration is
replaced by a probability distribution for S
 This is (ultimately) derived from observed data
 A simple process is assumed here to show
how the method works
 Assume there is a single time period until
expiration of the option
 The binomial model assumes the price of the
underlying asset must have one of two values
at expiration
Valuation of Options
 Let the initial price of the underlying asset be S
 The binomial assumption is that the price on
the expiration date is
 uS with probability p “up state”
 dS with probability 1- p “down state”
 These satisfy u > d
 Assume there is a riskfree asset with gross
return R = 1+ r
 It must be that u > R > d
Valuation of Options
 The value of the option in the up state is Vu
= max{uS – E, 0} for a call
= max{E – uS, 0} for a put
 The value of the option in the down state is Vd
= max{dS – E, 0} for a call
= max{E – dS, 0} for a put
 Denote the initial value of the option (to be
determined) by V0
 This information is summarized in a binomial
tree diagram
Valuation of Options

Stock Price uS
Option Value Vu
Probability p

Stock Price S Risk-free (gross) return R

Option Value V0

Probability 1 - p
Stock Price dS
Option Value Vd
Valuation of Options
 There are three assets
 Underlying asset
 Option
 Riskfree asset
 The returns on these assets have to related to
prevent arbitrage
 Consider a portfolio of one option and –  units
of the underlying stock
 The cost of the portfolio at time 0 is
P0 = V0 – S
Valuation of Options
 At the expiration date the value of the portfolio
is either
Pu = Vu - uS
 or
Pd = Vd - dS
 The key step is to choose  so that these are
equal (the hedging step)
 If  = (Vu – Vd)/S(u – d) then
Pu = Pd = (uVd – dVu)/(u – d)
Valuation of Options
 Now apply the arbitrage argument
 The portfolio has the same value whether the
up state or down state is realised
 It is therefore risk-free so must pay the risk-
free return
 Hence Pu = Pd = RP0
 This gives
R[V0 – S] = (uVd – dVu)/S(u – d)
Valuation of Options
 Solving gives
1 R d uR 
V0   Vu  Vd 
R u d ud 
 This formula applies to both calls and puts by
choosing Vu and Vd
 These are the boundary values
 The result provides the equilibrium price for
the option which ensures no arbitrage
 If the price were to deviate from this then risk-
free excess returns could be earned
Valuation of Options
 Consider a call with E = 50 written on a stock
with S = 40
 Let u = 1.5, d = 1.125, and R = 1.15
Stock Price uS = 60
Vu = max{60 – 50, 0} = 10
Probability p

Stock Price S Risk-free (gross) return

Option Value V0 R = 1.15

Probability 1 - p
Stock Price dS = 45
Vd = max{45 – 50, 0} = 0
Valuation of Options
 This gives the value
1  0.025 0.35 
V0   10  0
1.15  0.375 0.375 
 0.58
 For a put option the end point values are
Vu = max{50 – 60, 0} = 0
Vd = max{50 – 45, 0} = 5
 So the value of a put is
1  0.025 0.35 
V0   0 5  4.058
1.15  0.375 0.375 
Valuation of Options
 Observe that
40 + 4.058 – 0.58 = 43.478
 And that
(1/1.15) 50 = 43.478
 So the values satisfy put-call parity
S + Vp – Vc = (1/R)E
Valuation of Options
 The pricing formula is
1 R d uR 
V0   Vu  Vd 
R ud ud 
 Notice that
Rd uR Rd uR
 0, 0  1
ud ud ud ud
 So define
Rd
q
ud
Valuation of Options
 The pricing formula can then be written
1
V0   qVu  [1  q ]Vd 
R
 The terms q and 1 – q are known as risk
neutral probabilities
 They provide probabilities that reflect the risk
of the option
 Calculating the expected payoff using these
probabilities allows discounting at the risk-free
rate
Valuation of Options
 The use of risk neutral probabilities allows the
method to be generalized
q Vuu = max{uuS – E, 0} for a call

Vu
= max{E – uuS, 0} for a put
q 1–q
V0
Vud= Vdu = max{udS – E, 0} for a call
q
1–q = max{E – udS, 0} for a put
Vd

1–q
Vdd = max{ddS – E, 0} for a call

= max{E – ddS, 0} for a put

Valuation of Options
 u and d are defined as the changes of a single
interval
 R is defined as the gross return on the risk-free
asset over a single interval
 For a binomial tree with two intervals the value
of an option is

V0 
1
R 2
q V
2
uu
2
 2q (1  q )Vud  (1  q) Vdd 
Valuation of Options
 With three intervals
V0 
1
R 3
q V
3
uuu  3q 2
(1  q )Vuud  3q (1  q ) 2
Vudd  (1  q ) 3
Vddd 
 Increasing the number of intervals raises the
number of possible final prices
 The parameters p, u, d can be chosen to
match observed mean and variance of the
asset price
 Increasing the number of periods without limit
gives the Black-Scholes model