What is Option Replication Using Put-Call Parity?

Options trading can be a complex but rewarding field for investors. One of the fundamental concepts within options trading is put-call parity, a principle that helps traders understand the relationship between put and call options. This article explores how option replication can be achieved using put-call parity, providing an in-depth look at its formula, practical applications, and various nuances.

Table of Contents

What is Option Replication?

Option replication involves creating a portfolio that mimics the payoff of an option. By understanding and utilizing put-call parity, traders can replicate options and exploit arbitrage opportunities. This technique is crucial for constructing hedging strategies and ensuring market efficiency.

Put-Call Parity: An Overview

Put-call parity is a financial theory that defines a specific relationship between the price of European put and call options with the same strike price and expiration date. This relationship helps traders understand how the prices of these options should behave relative to each other.

Put-Call Parity Formula

The put-call parity formula is expressed as:

[ C + PV(K) = P + S ]

Where:

( C ) = Price of the call option
( P ) = Price of the put option
( S ) = Current stock price
( PV(K) ) = Present value of the strike price ( K ), discounted at the risk-free interest rate

This equation illustrates that the combination of a call option and the present value of the strike price should equal the combination of a put option and the current stock price.

Example: Option Replication Using Put-Call Parity

To illustrate option replication using put-call parity, consider the following example:

Current stock price (S): $100
Strike price (K): $100
Call option price (C): $10
Put option price (P): $5
Risk-free interest rate: 5% per annum
Time to expiration: 1 year

First, calculate the present value of the strike price:
[ PV(K) = \frac{K}{(1 + r)^t} = \frac{100}{(1 + 0.05)^1} = \frac{100}{1.05} \approx 95.24 ]

According to the put-call parity formula:
[ C + PV(K) = P + S ]
[ 10 + 95.24 = 5 + 100 ]
[ 105.24 = 105 ]

The slight discrepancy is due to rounding, but the principle holds. Traders can replicate the payoff of a call option by holding a portfolio of the underlying stock and a put option, adjusted for the present value of the strike price.

Put-Call Parity Arbitrage

Arbitrage opportunities arise when the put-call parity relationship does not hold. Traders can exploit these discrepancies by constructing arbitrage portfolios that lock in risk-free profits. For example, if the left side of the equation is greater than the right side, a trader could sell the call option and the present value of the strike price while buying the put option and the stock.

Put-Call Parity with American Options

American options can be exercised at any time before expiration, unlike European options, which can only be exercised at expiration. This flexibility introduces complexities in the put-call parity relationship. Adjustments must be made to account for the possibility of early exercise, often resulting in slight deviations from the strict parity observed with European options.

Put-Call Parity with Dividends

When the underlying stock pays dividends, the put-call parity formula needs to be adjusted to account for the expected dividend payments. The modified formula is:
[ C + PV(K) = P + S – PV(D) ]
Where ( PV(D) ) represents the present value of the dividends expected to be paid before the option’s expiration.

Put-Call Forward Parity

Put-call forward parity extends the concept to forward contracts. The formula for put-call forward parity is:
[ C – P = (F – K) / (1 + r)^t ]
Where ( F ) is the forward price of the underlying asset. This relationship helps traders understand how the prices of options and forward contracts interact.

Proof of Put-Call Parity

The theoretical proof of put-call parity involves constructing two portfolios with identical payoffs and demonstrating that their values must be equal to prevent arbitrage. Consider a portfolio consisting of a long call option and a short put option, both with strike price ( K ) and expiration ( t ). The payoff at expiration is:
[ \max(S_t – K, 0) – \max(K – S_t, 0) = S_t – K ]

This payoff is identical to holding the underlying stock and borrowing the present value of ( K ). Thus, the initial costs of these portfolios must be equal, leading to the put-call parity relationship.

Using a Put-Call Parity Calculator

Online calculators can simplify the application of put-call parity by automating the calculations. These tools allow traders to input the necessary parameters and quickly determine whether the put-call parity relationship holds, identifying potential arbitrage opportunities.

Conclusion

Put-call parity is a cornerstone of options trading, providing a framework for understanding the relationship between put and call options. By mastering this concept, traders can replicate options, exploit arbitrage opportunities, and develop robust trading strategies. Understanding the nuances of put-call parity with American options, dividends, and forward contracts further enhances a trader’s ability to navigate the options market effectively.