© Markus Rudolf Arbitrage

Prof. Dr. Markus Rudolf

Dresdner Bank chair of finance
WHU, Otto Beisheim graduate school of management

Internet: http://www.whu.edu/banking

Options and Futures

7th semester lecture

Arbitrage 1. Basics
2. Parities
3. Lower price boundaries
4. Convexity
5. Pure assets
Reference: Hull (1997), chapter 8

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© Markus Rudolf Arbitrage

Basics
Arbitrage

Replication: In order to determine the value of a derivative instrument, a

replicating position of basis instruments is constructed.
Value equivalence principle - law of one price: If two strategies provide the
same payoff in all future states of the world, the price of those two instruments
must be equal.
Arbitrage: Riskless infinite gain without any capital investment

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Parities
Put Call Forward Parity

Cash flow
today Cash flow at maturity
Stock price S 800 900 1000 1050 1200
Long Call (X=F=1050) C 0 0 0 0 150
Short Put (X=F=1050) -P -250 -150 -50 0 0
Long Call + Short Put C-P -250 -150 -50 0 150
Long Forward (F=1050) F -250 -150 -50 0 150

200 S = 1000, r = 5%, Forward price F =

150
Value of components at

1050, C = P = 50
100
50
The combination of a long position in
maturity

0
-50 a call and a short put position yields
-100 the same payoff like a forward
-150
-200 contract, if the exercise price equals
-250 the forward price:
-300
800 900 1000 1100 1200
C(X = F) - P(X = F) = F = 0
Stock price
C(X = F) = P(X = F)

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Parities
Spot Futures Parity

S = 1000, r = 5%, futures maturity T = 1 year, the stock pays a dividend of 30

after 90 days which is reinvested until the maturity of the futures; assume the
forward price is F = 1040

29.65 30 31.10

Today t=0 Dividend Futures maturity

payment t=90 t = 360
270
Value of D=30 in t = 360: 30 × 1.05 360 = 31.1
Value of D=30 today: 31.1 × 1.05 -1 = 29 .65

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Parities
Spot Futures Parity

Cashflow Cashflows at maturity

today
Forward price
Stock 800 900 1000 1100 1200
price = spot price
(A) 0 -240 -140 -40 60 160 + Interest
Buy forward (F=1040)
-1000 800 900 1000 1100 1200
- Reinvested dividend
(B) Index portfolio
Dividend 31.1 31.1 31.1 31.1 31.1
F = S · (1+r) - FV (D)
Loan #1 +1000 -1050 -1050 -1050 -1050 -1050
+20.1 -21.1 -21.1 -21.1 -21.1 -21.1
Loan #2 1018.9 = 1000 · 1.05 -31.1
Replicating portfolio 20.1 -240 -140 -40 60 160

F = [S - PV (D )] × [1 + R ]T
(C)
Forward sell (F=1040) 0.00 240 140 40 -60 -160
Long replicating portfolio 20.1 -240 -140 -40 60 160
Arbitrage position 20.1 0 0 0 0 0
(D)
Buy Forward (F=1018.9) 0 -218.9 -118.9 -18.9 81.1 181.1

Index Portfolio -1000 800 900 1000 1100 1200

Dividend 31.1 31.1 31.1 31.1 31.1
-Loan #1 1000 -1050 -1050 -1050 -1050 -1050
Replicating portfolio 0 -218.9 -118.9 -18.9 81.1 181.1

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Parities
Put Call Parity

Position Value at maturity

Stock 800 850 900 950 1000
price
Stock 1000 800.0 850.0 900.0 950.0 1000.0
Dividend 31.1 31.1 31.1 31.1 31.1
Put option (X=900) P 100.0 50.0 0.0 0.0 0.0
1000+P 931.1 931.1 931.1 981.1 1031.1
Money market 857.15 900.0 900.0 900.0 900.0 900.0
account PV360t(900)
Money market 29.65 31.1 31.1 31.1 31.1 31.1
account PV90t(30)
Call option (X=900) C 0.0 0.0 0.0 50.0 100.0
886.8+C 931.1 931.1 931.1 981.1 1031.1

1000 + P = 886.80 + C <=> S + P = PV (X+D) + C

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Parities
General put call futures Parity

Cashflows at maturity
800 900 1000 1100 1200
Put (X=900) P 100 0 0 0 0
Call C 0.0 0 100.0 200.0 300.0
*
Loan PV360t(118.9 ) 113.2 -118.9 -118.9 -118.9 -118.9 -118.9
Forward sell 0 218.9 118.9 18.9 -81.1 -181.1
(F=1018.9)
C+113.2 100.0 0.0 0.0 0.0 0.0

*: 118.9 = F - X = 1018.9 - 900

P = 113.2 + C
More general: P (X) + F = PV (F-X) + C, which is the put call futures parity
A put option is replicated by a strategy consisting of a long call position, a
forward sell of stocks, and a loan by the amount of the difference between the
forward price and the strike.

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Parities
Futures forward equivalence

Period Spot price Interest Rate Forward Price

0 S0 1000 R3 5% F0=1000×1.053= 1.157,63
1 S1 1110 R2 6% F1=1110×1.062= 1.247,20
2 S2 1080 R1 7% F2=1080×1.071= 1.155,60
3 S3 1200 F3=1200×1.000= 1.200,00

The table above shows a scenario for stock price movements and for the
corresponding forward prices.
The payoff of the forward contract at maturity in t=3 is:
ST -F0 = 1200 – 1157.63 = 42.37
This example assumes constant interest rates over time. I.e. interest rates and
spot prices are uncorrelated.

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Parities
Futures forward equivalence
1
Second strategy (with futures): In the beginning of each period t [1 + R (t + 1,T )]T - t -1
futures contracts are purchased without any costs. They are settled at the end of
each period (cash settlement). If the term structure is constant, i.e. uncorrelated
with the spot prices, the corresponding cashflows are:
Settlement:
Number of Value of one Value of our Final value of
contracts futures futures our futures
Period Spot price R3 R2 R1 purchased contract contracts contratcs
0 1000 5% 6% 7% 0,8900
1 1110 6% 7% 0,9346 89,57 79,72 89,57
2 1080 7% 1 -91,60 -85,60 -91,60
3 1200 44,40 44,40 44,40
Sum 42,37

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Parities
Futures forward equivalence

Obviously, the futures strategy and the forward strategy have the same payoffs
without any initial investments.
Forward and futures prices are equal, if interest rates are perfectly predictable
(deterministic) or uncorrelated to stock prices. Price differences between forwards
and futures only occur in the case of stochastic interest rates. If interest rates are
correlated to stock prices, the costs of carry have to be taken into account:

rIR,stocks > 0 and stock prices go up rIR,stocks < 0 and stock prices go down
The costs of capital of the short The costs of capital of the long
position goes up, because the position goes up, because the
amount in the margin account has to amount in the margin account has to
be rewarded by higher interest rate be rewarded by higher interest rate
payments, when margin calls occur payments, when margin calls occur
for the short position for the long position
Futures price > Forward price Futures price < Forward price

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Parities
Stocks and interest rates are correlated

Positive Settlement:
correlation Number of Value of one Value of our Final value of
contracts futures futures our futures
Period Spot price R3 R2 R1 purchased contract contracts contratcs
0 1000 5% 6% 7% 0,8900
1 1110 7% 8% 0,9259 89,57 79,72 91,27
2 1080 7% 1 -91,60 -84,81 -90,75
3 1200 44,40 44,40 44,40
Sum 44,92

Negative Settlement:
correlation Number of Value of one Value of our Final value of
contracts futures futures our futures
Period Spot price R3 R2 R1 purchased contract contracts contratcs
0 1000 5% 6% 7% 0,8900
1 1110 5% 6% 0,9434 89,57 79,72 87,89
2 1080 7% 1 -91,60 -86,41 -92,46
3 1200 44,40 44,40 44,40
Sum 39,83

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Lower Price Boundaries

Call options

Exercise Value Call = max (0, Stock Price - Exercise Price) = max (0, S - X)

S=1000, X=900, ST=1200 => Exercise value Call = 300

Position at maturity: 1 stock: 1200 Loan: -900
Sum: 300 Equal to call option if it is in the money
900
Position today: 1 stock: 1000 Loan: PV 360T (900) = = 857.15
Sum: 142.85 1.051

Position Value Stock price at maturity

today
800 850 900 950 1´000
1 Call (X=900) C 0 0 0 50 100
1 Stock -1´000 800 850 900 950 1´000
Loan 857.15 -900 -900 -900 -900 -900
Total -142.85 -100 -50 0 50 100

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Lower Price Boundaries

Call options - arbitrage strategy

The minimum value of the call option equals the value of the stock + loan position
=> The minimum call option price is 142.85

C ³ 1000 - PV360t (900) = 142.85

Otherwise, arbitrage opportunities would occur: Assume, the price of the call
option would be 120:
Purchase the call: -120
Short sell of the stock: 1000
Fixed income investment: -857.15 Sum: 22.85
Stock price at maturity
800 850 900 950 1000
Call 0 0 0 50 100
Stock short
position -800 -850 -900 -950 -1000
FI investment 900 900 900 900 900
100 50 0 0 0

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© Markus Rudolf Arbitrage

Lower Price Boundaries

Call options - The value of an option is never negative ...

Assume the exercise price would be X = 1100.

C ³ 1000 - PV360t (1100) = 1000 - 1047.62 = -47.62

However, the payoff at maturity has a lower boundary of 0: CT = max [-47.62,0]

In the worst case, the long call position would get nothing at maturity. Nobody
would accept a contract revealing a negative payoff without getting anything.
Therefore, the minimum price is zero.
Intuition: Volatility in stock prices is always positive for the option holder and never
negative. Even an option which is deeply out of the money has a slight chance to
end in the money. This is due to the stock price volatility. Even the tiny chance to
get something will not have a negative value.
Clower boundary = max[0, S - PVt(X)]

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Lower Price Boundaries

Call options - price sensitivities

Non dividend and dividend paying call Upper boundary for call
options
1400
Lower and upper

1200 Lower boundaries for

1000
boundary

800
dividend paying and non
600 dividend paying call options
400
200
0
0 500 1000
Stock price

The call price is the higher, the

... higher the stock price is
... lower the exercise price is
... the higher the risk free rate of interest is
Dividend payments: Dividend payment of 30 € occurs after 30 days, r=5%

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Lower Price Boundaries

Call options - with dividend payments

Dividend payments: Dividend payment of 30 occurs after 90 days, r=5%

Position Value today Stock price ex dividend a maturity

800 850 900 950 1000
1 Call C 0 0 0 50 100
1 Stock -1´000 incl. 800.0 850.0 900.0 950.0 1000.0
FV (dividend) dividend 31.1 31.1 31.1 31.1 31.1
Loan
PV360t(900) 857.15 -900.0 -900.0 -900.0 -900.0 -900.0

Loan PV90t(30) 29.65 -31.1 -31.1 -31.1 -31.1 -31.1

Total -113.2 -100 -50 0 50 100

Lower boundary is 113.2: The value of the dividend is reflected by the stock price.
Until the maturity of the call, the stock is ex dividend. Therefore, dividend
payments reduce the stock price.
Clower boundary = max[0, S - PVt(X) - PVd(D)]

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Lower Price Boundaries

Put options

Position Value Stock value at maturity (excluding dividend payments)

today
1000 1050 1100 1150 1200

1 Put P 100.0 50.0 0.0 0.0 0.0

1 Stock 1000 incl. 1000.0 1050.0 1100.0 1150.0 1200.0
FV (Dividend) dividend 31.1 31.1 31.1 31.1 31.1

P + 1000 1131.1 1131.1 1131.1 1181.1 1231.1

Investment
PV360t(1100) 1047.6 1100.0 1100.0 1100.0 1100.0 1100.0
Investment 29.6 31.1 31.1 31.1 31.1 31.1
PV90t(30)
1077.2 1131.1 1131.1 1131.1 1131.1 1131.1

S = 1000 X = 1100 r = 5% D = 30 (paid in 90 days)

Maturity = 1 year
Plower boundary = max [PV (X) + PV (D) - S,0]
Pupper boundary = X

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Convexity
... and exercise price

Option price
Exercise
Case A is not possible due to the
price Maturity Case A Case B no arbitrage assumption: Vertical
X1=900 12M 160 160 spread arbitrage strategy
X2=1000 12M 50 100
X3=1100 12M 10 10

Value today Stock value at option maturity

900 950 1000 1050 1100 1150
Short call
position
(X 1 = 900) 160 0 -50 -100 -150 -200 -250
Long call
position
(X 2 = 1000) -50 0 0 0 50 100 150
Sum 110 0 -50 -100 -100 -100 -100

The payoff today is positive (110), the liabilities at maturity are 100 (PV = 95.23)
at maximum. The minimum arbitrage profit therefore is 14.77.

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Convexity
... and exercise price

In order to avoid arbitrage opportunities: The difference between the option

prices must be smaller than the present value of the difference of the exercise
prices:
PV (X1- X2) > C(X2) - C(X1)
Case B is as well not possible due to the no arbitrage assumption: Butterfly
spread arbitrage strategy
Value today Stock value at option maturity
900 950 1000 1050 1100 1150
Long call
position
(X 1 = 900) -160 0 50 100 150 200 250
2 Short call
positions
(X 2 = 1000) 200 0 0 0 -100 -200 -300
Long call
position
(X 3 = 1100) -10 0 0 0 0 0 50
Sum 30 0 50 100 50 0 0

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© Markus Rudolf Arbitrage

Convexity
... and exercise price

This strategy provides a profit of 30 today and possible profits at maturity. The
price of the call option (X2 = 1000) is too high. Assume a price for the second
call of 80:

Value today Stock value at option maturity

900 950 1000 1050 1100 1150
Long call
position
(X 1 = 900) -160 0 50 100 150 200 250
2 Short call
positions
(X 2 = 1000) 160 0 0 0 -100 -200 -300
Long call
position
(X 3 = 1100) -10 0 0 0 0 0 50
Sum -10 0 50 100 50 0 0

The arbitrage opportunity disappears.

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Convexity
... and exercise price

180 In the initial example,

160 the price of the second
140 call option (X2 = 1000)
Call Option Price

120 was to high. The call

100 option price is a
80 decreasing convex
60 function of the exercise
40 price.
20
0
800 900 1000 1100 1200
Exercise Price
C(X1 = 900) + C(X 3 = 1100) 160 + 10
C(X 2 = 1000) £ £ = 85
2 2
The figure illustrates the relationship between the option prices, how they are
and how they should be.

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© Markus Rudolf Arbitrage

Convexity
... and stock price

250 The call price is an

increasing convex
200 function of the stock
Call option price

price. The lower

150
boundary is given
100 linearly as before.

50

0
600 700 800 900 1000 1100 1200
Stock price

d 2 C(X) > 0 Convexity means that option price differences go down as the
d X2 strike price goes up.

d 2 C(X) > 0 And it means that option price differences go down as the stock
d S2 price goes up.

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Convexity
... and time to maturity

250 The closer to maturity,

the closer the value of
200 the call will be to the
Call option price

Times to maturity:
1 year lower price boundary.
150
6 months This is due to the fact,
100 3 months that volatility is the
greater, the longer the
50 option is to maturity.
0
600 700 800 900 1000 1100 1200
Stock price

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© Markus Rudolf Arbitrage

Pure assets
Butterfly spread

Pure assets: payoff is 1 currency unit in one state of the world and 0 in all other
states => can be replicated by butterfly spread strategies. Assume the following
pricing structure:
C(X= 800) = 215 This pricing structure is free of arbitrage
C(X= 850) = 185 according to the principles laid down before:
C(X= 900) = 160 The difference of the prices is below the
C(X= 950) = 140 difference of the present values of the exercise
C(X=1000) = 125 prices, and the price difference is decreasing.
Based on this setting, three different butterfly spread strategies are illustrated in
the following table.
All spreads cost 5 => a pure asset for all states of the world would cost 0.1
In the real world, one can expect different willingnesses of payments depending
on which states imply hedging needs => the worse the market performs, the
more the investors are willing to pay for a pure security of this particular state

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Pure assets
Butterfly spread

Value Stock value at maturity of the option

today
800 850 900 950 1000
1 Call long (X=800) 215 0 50 100 150 200
2 Calls short (X=850) -370 0 0 -100 -200 -300
1 Call long (X=900) 160 0 0 0 50 100
"Spread 850" 5 0 50 0 0 0
1 Call long (X=850) 185 0 0 50 100 150
2 Calls short (X=900) -320 0 0 0 -100 -200
1 Call long (X=950) 140 0 0 0 0 50
"Spread 900" 5 0 0 50 0 0
1 Call long (X=900) 160 0 0 0 50 100
2 Calls short (X=950) -280 0 0 0 0 -100
1 Call long (X=1000) 125 0 0 0 0 0
"Spread 950" 5 0 0 0 50 0

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Pure assets
Butterfly spread

Exercise Option Difference Difference of difference

price price = Butterfly spreads price
X C DC D (DC)

800 215
850 185 30 5 (= Price of "Spread 850")
900 160 25 5 (= Price of "Spread 900")
950 140 20 5 (= Price of "Spread 950")
1000 125 15

The price of a pure asset always equals the difference of the difference of
the option prices.
Spread 900 C(850) - 2 C(900) + C(950)
P(1 for S = 900) = =
50 50
=
[C(X = 950) - C(X = 900)] - [C(X = 900) - C(X = 850)]
50
140 - 2 * 160 + 185 [140 - 160] - [160 - 185] 5
= = = = 0.1
50 50 50
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Pure assets
Butterfly spread

First differences: Second difference:

C (X-D)
C (X) - C (X-D)
C (X) C (X+D) - 2·C (X) + C (X-D)
C (X+D) - C (X)
C (X+D)

Price of a butterfly spread

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© Markus Rudolf Arbitrage

Pure assets
... pricing and risk aversion

The following structure of call option prices reflects risk aversion:

C(X= 800) = 225 Spread 850 costs three times as much as spread 950
C(X= 850) = 185 => This is caused by risk aversion, people pay more
C(X= 900) = 160 for payoffs in low states than in high states
C(X= 950) = 145
C(X=1000) = 135

Exercise Option Difference Difference of differences

price price = Pure asset prices
X C DC D (D
DC)
800 225
850 185 40
900 160 25 15 (= Price of the "Spread 850")
950 145 15 10 (= Price of the "Spread 900")
1000 135 10 5 (= Price of the "Spread 950")

Option price differences go down increasingly with the strike going up.

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Pure assets
... pricing and risk aversion

Convexity condition: d 2 C(X) > 0

d X2

Risk aversion d 2 C(X) > 0

condition:
d X2

Prices of pure assets are equal to prices of butterfly spreads. The price of a
butterfly spread equals the difference of the difference of the underlying option
prices.
The difference of differences is the convexity: Convexity measures the implicit
price of pure assets.
Risk aversion implies increasing convexity with the strike price going down.

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