ECO 4378

Instructor: Saltuk Ozerturk

1. Arbitrage when call price is below its lower bound

• We have established that the price of a call option with strike price X
must satisfy:
X
c> S0 −
| {z1 + r}
lower bound on call price

The following example illustrates that when the above relationship does
not hold (i.e., when the call price is below its lower bound), then there
is an arbitrage opportunity.

• Example 1: Consider a call option on IBM stock with strike price

X = $55 and which has 6 months until expiration. The current IBM
stock price is S0 = $70 and the 6-month risk free rate of return is
r = 10%. The price of this call option is c = 12. Let us first illustrate
that the call price is lower than its lower bound. To see this, note that
the lower bound is given by
X 55
Lower Bound = S0 − = 70 − = 20
1+r 1.10
whereas the call price is c = 12 and it is lower than the lower bound.

— Arbitrage position: Buy the call option at c = 12. Sell the

stock short at S0 = $70. Invest the proceeds 70 − 12 = 58 at
r = 10%.
— At the expiration date, the arbitrage trader must close the short
stock position. In other words, he/she needs to buy one share of
the stock. To prove that the above position always makes a profit,
we need to consider two cases.
∗ If ST > 55 : In this case, the trader buys the stock through
his/her call option. The payoff to the arbitrage position is
given by

58(1.10) + (ST − 55) − ST = $8.8 > 0

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 ∗ If ST < 55 : In this case, the trader buys the stock directly in
the market at ST . Call option is not exercised. The payoff to
the arbitrage position is given by

58(1.10) − ST = 63.8 − ST > 0 for ST < 55.

• Exercise 1: A European call option (on a stock) that expires in 6

months has a strike price of $88. The current stock price is $90 and
the 6-month risk free interest rate is 10%.

— a) What is the lower bound for the price of that call? Identify the
arbitrage strategy if the call price is c = 8.
— b) For the arbitrage strategy you described above, find the arbi-
trage profit when at expiration the stock price turns out to be ST
= 60.
— c) What is the arbitrage profit if ST = 90?

2. Arbitrage when put price is below its lower bound

• We have established that the price of a put option with strike price X
must satisfy:
X
p> − S0
|1 + r{z }
lower bound on put price

The following example illustrates that when the above relationship does
not hold (i.e., when the put price is below its lower bound), then there
is an arbitrage opportunity.

• Example 2: Consider a put option on IBM stock with strike price

X = $110 and which has 6 months until expiration. The current IBM
stock price is S0 = $90 and the 6-month risk free rate of return is
r = 10%. The price of this put option is p = 8. Let us first illustrate
that the put price is lower than its lower bound. To see this, note that
the lower bound is given by
X 110
Lower Bound on put price = − S0 = − 90 = 10
1+r 1.10
whereas the put price is p = 8 and it is below the lower bound.

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 — Arbitrage position: Buy the put option at p = 8. Buy the stock
at S0 = $90. To finance this arbitrage portfolio position, borrow
p + S0 = 8 + 90 = 98 at r = 10%.
— At the expiration date, the arbitrage trader must pay back the
loan. To prove that the above position always makes a profit, we
need to consider two cases.
∗ If ST < 110 : In this case, the trader sells the stock through
his/her put option. The payoff to the arbitrage position is
given by
(110 − ST ) + ST − 98(1.10) = 2.2
∗ If ST > 110 : In this case, the trader sells the stock directly
in the market at ST . Put option is not exercised. The payoff
to the arbitrage position is given by

ST − 98(1.10) > 0 for ST > 110.

• Exercise 2: A European put option (on a stock) that expires in 6

months has a strike price of $44. The current stock price is $33 and
the 6-month risk free interest rate is 10%.

— a) What is the lower bound for the price of that put? Identify the
arbitrage strategy if the put price is p = 5.
— b) For the arbitrage strategy you described above, find the arbi-
trage profit when at expiration the stock price turns out to be ST
= 50.
— c) What is the arbitrage profit if ST = 30?

3. Arbitrage when put-call parity does not hold

• We have established that the price of a put option with strike price
X and the price of a call option with strike X (written on the same
underlying asset) must satisfy:
X
p + S0 = c +
1+r
The following example illustrates that when the above relationship does
not hold, then there is an arbitrage opportunity.

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• Example 3: Consider a put option on IBM stock with strike price
X = $110 and which has 6 months until expiration. The current IBM
stock price is S0 = $90 and the 6-month risk free rate of return is
r = 10%. The price of this put option is p = 8. The price of the call
option on the IBM stock with strike price X = $110 and with the same
expiration date is c=10. Let us first illustrate that the put-call parity
does not hold. To see this, note that
X 110
p + S0 = 8 + 90 = 98 < c + = 10 + = 110
1+r 1.10
— Arbitrage position: Buy the put option at p = 8. Buy the
stock at S0 = $90. Sell the call option at c = 10. To finance this
position, borrow p + S0 − c = 8 + 90 − 10 = 88 at r = 10%.
— Payoff to the above arbitrage position:
∗ If ST < 110, payoff is (the trader exercises the put option)

(110 − ST ) + ST − 88(1.10) = 13.2

∗ If ST > 110, payoff is (the short call exercised)

ST − (ST − 110) − 88(1.10) = 13.2

In both cases, the trader ends up selling the stock at X =

$110.

• Exercise 3: Consider a European call option and a put option on a

stock each with a strike price of X = $22. The price of call is c = $4
and the price of put is p = $3. The 6-month risk free rate of interest is
r = 10%. The current stock price is S0 = $20. Identify the arbitrage
strategy and find out the arbitrage trader’s profit as a function of ST .