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Lecture 4. 20.10.2014
Options (continued).
Because the value of an option at expiry is so sensitive to price it reects
movements in the price of the underlying in exaggerated form the holding
(or more generally, trading) of options and other derivatives presents greater
opportunities for prot (and indeed, for loss) than trade in the underlying
(this is why speculators buy options!). They are correspondingly more risky
than the underlying.
One of the main insights of the fundamental work of Black and Scholes
was that one can (at least in the most basic model) hedge against meeting
a contingent claim by replicating it: constructing a portfolio, adjusted or rebalanced as time unfolds and new price information comes in, whose pay-o
is the amount of the contingent claim.
6. Arbitrage.
Economic agents go to the market for various reasons. One the one hand,
companies may wish to insure, or hedge, against adverse price movements
that might aect their core business. On the other hand, speculators may
be uninterested in the specic economic background, but only interested in
making a prot from some nancial transaction. The relation between hedging (good) and speculation (bad) is to some extent symbiotic (one cannot
lay o a risk unless someone else is prepared to take it on, and why should he
unless he expects to make money by doing so). Nevertheless, one feels that it
should not be possible to extract money from the market without genuinely
engaging in it, by taking risk: all business activity is risky. Indeed, were it
possible to do so, people would do so in unlimited quantities, thus sucking
money parasitically out of the market, using it as a money-pump. This
would undermine the stability and viability of the market in the long run
and in particular, make it impossible for the market to be in equilibrium.
The usual theoretical view of modelling markets as NA is not so much
that arbitrage opportunities do not exist, but rather that if they do exist in
any sizeable quantity, people will rush to exploit them, and by doing so will
dissipate them arbitrage them away.
OED: 3 [Comm.]. The trac in Bills of Exchange drawn on sundry places,
and bought or sold in sight of the daily quotations of rates in the several
markets. Also, the similar trac in Stocks. 1881.
Used in this broad sense, the term covers nancial activity of many kinds,
including trade in options, futures and foreign exchange. However, the term
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arbitrage is nowadays also used in a narrower and more technical sense. Financial markets involve both riskless (bank account) and risky (stocks, etc.)
assets. To the investor, the only point of exposing oneself to risk is the opportunity, or possibility, of realising a greater prot than the riskless procedure of
putting all ones money in the bank (the mathematics of which compound
interest does not require a degree or MSc course!). Generally speaking,
the greater the risk, the greater the return required to make investment an
attractive enough prospect to attract funds. Thus, for instance, a clearing
bank lends to companies at higher rates than it pays to its account holders.
The companies trading activities involve risk; the bank tries to spread the
risk over a range of dierent loans, and makes its money on the dierence
between high/risky and low/riskless interest rates.
It is usually better to work, not in face-value or nominal terms, but in
discounted terms, allowing for the exponential growth-rate ert of risklessly
invested money. So, prot and loss are generally reckoned against this discounted benchmark.
The above makes it clear that a market with arbitrage opportunities
would be a disorderly market too disorderly to model. The remarkable
thing is the converse. It turns out that the minimal requirement of absence
of arbitrage opportunities is enough to allow one to build a model of a nancial market which while admittedly idealised (frictionless market no
transaction costs, etc.) is realistic enough both to provide real insight
and to handle the mathematics necessary to price standard options (BlackScholes theory). We shall see that arbitrage arguments suce to determine
prices the arbitrage pricing technique (APT).
Short-selling. First, consider a riskless asset (bank account), with interestrate r > 0. If our bank deposit is positive, we lend money and earn interest
at rate r. If our bank deposit is negative (overdraft), we borrow money and
pay interest. [We assume for simplicity that we pay interest also at rate r,
though in practice of course it will be at some higher rate r > r. Models
taking these dierent interest-rates into account are topical at research level;
we omit them here see VI.5].
In many markets, risky assets such as stocks may be treated in the same
way. We may have a positive or zero holding or a negative holding (notionally borrowing stock, which we will be obliged to repay or repay its
current value). In particular, we may be allowed to sell stock we do not
own. This is called short-selling, and is perfectly legal (subject to appropriate regulation) in many markets. Think of short-selling as borrowing. Not
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only is short-selling both routine and necessary in some contexts, such as

foreign exchange and commodities futures, it simplies the mathematics. So
we assume, unless otherwise specied, no restriction on short-selling. By extension, we call a portfolio, or position, short in an asset if the holding of the
asset is negative, long if the holding of the asset is positive.
Note. It turns out that in some important contexts such as the BlackScholes theory of European and American calls short-selling can be avoided.
In such cases, it is natural and sensible to do so: see Ch. VI.
7. Put-Call Parity.
Just as long and short positions are diametrical opposites, so are call and
put options. We now use arbitrage to show how they are linked.
Suppose there is a risky asset, value S (or St at time t), with European
call and put options on it, value C, P (or Ct , Pt ), with expiry time T and
strike-price K. Consider a portfolio which is long one asset, long one put
and short one call; write (or t ) for the value of this portfolio. So
=S+P C

(S: long asset; P: long put; -C: short call).

Recall that the payos at expiry are:

{

max(S K, 0) or (S K)+ for a call,

max(K S, 0) or (K S)+ for a put.

So the value of the above portfolio at expiry is

{

S + 0 (S K) = K if S K
S + (K S) 0 = K if K S,

namely K. This portfolio thus guarantees a payo K at time T . How much

is it worth at time t?
Short answer (correct, and complete): Ker(T t) , because it is nancially
equivalent to cash K, so has the same time-t value as cash K.
Longer answer (included as an example of arbitrage arguments). The
riskless way to guarantee a payo K at time T is to deposit Ker(T t) in the
bank at time t and do nothing. If the portfolio is oered for sale at time t
too cheaply at a price < Ker(T t) I can buy it, borrow Ker(T t) from
the bank, and pocket a positive prot Ker(T t) > 0. At time T my
portfolio yields K (above), while my bank debt has grown to K. I clear my
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cash account use the one to pay o the other thus locking in my earlier
prot, which is riskless. If on the other hand the portfolio is oered for sale
at time t at too high a price at price > Ker(T t) I can do the exact
opposite. I sell the portfolio short that is, I buy its negative, long one call,
short one put, short one asset, for , and invest Ker(T t) in the bank,
pocketing a positive prot () Ker(T t) = Ker(T t) > 0. At time
T , my bank deposit has grown to K, and I again clear my cash account
use this to meet my obligation K on the portfolio I sold short, again locking
in my earlier riskless prot. So the rational price for the portfolio at time t
is exactly Ker(T t) . Any other price presents arbitrageurs with an arbitrage
opportunity (to make a riskless prot) which they will take! Thus
(i) The price (or value) of the portfolio at time t is Ker(T t) , that is,
S + P C = Ker(T t) .
This link between the prices of the underlying asset S and call and put options on it is called put-call parity.
(ii) The value of the portfolio S + P C is the discounted value of the riskless
equivalent. This is a rst glimpse at the central principle, or insight, of the
entire subject of option pricing.
(iii) Arbitrage arguments, although apparently qualitative, have quantitative conclusions, and allow one to calculate precisely the rational price or
arbitrage price of a portfolio. The put-call parity argument above is the
simplest example though a typical one of the arbitrage pricing technique.
(iv) The arbitrage pricing technique is due to S. A. Ross in 1976-78 (details
in [BK], Preface). Put-call parity has a long history (see Wikipedia).
Note. 1. History shows both that arbitrage opportunities exist (or are
sought) in the real world and that the exploiting of them is a delicate matter.
The collapse of Barings Bank in 1995 (the UKs oldest bank, and bankers to
HMQ) was triggered by unauthorised dealings by one individual, who tried
and failed to exploit a ne margin between the Singapore and Osaka Stock
Exchanges. The leadership of Barings Bank at that time thought that the
trader involved had discovered a clever way to exploit price movements in
either direction between Singapore and Osaka. This is obviously impossible
on theoretical grounds, to anyone who knows any Physics. See Problems 2
Q1 (key phrases: perpetual motion machine; Maxwells demon; Second Law
of Thermodynamics; entropy).
2. Major nance houses have an arbitrage desk, where their arbs work.