Level I - DerivativesMAIL.

COM
C E @ G
FI N A N
O O K S
M B
Option
A Replication Using Put–Call Parity
EX www.ift.world

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Reproduced and republished with permission from CFA Institute. All rights reserved.

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 Contents and Introduction
1. Introduction
2. Put–Call Parity
3. Option Strategies Based on Put–Call Parity
4. Put–Call Forward Parity and Option Applications
5. Put–Call Forward Parity
L . CO M
6.
@ G
Option Put–Call Parity Applications: Firm Value
E MAI
SFI N ANC
AM B OOK
EX

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 1. Introduction
This reading covers:
• Put-call parity for European options
• Put-call forward parity for European options
• Put-call parity application to explain firm value

L . CO M
E @ G MAI
SFI N ANC
AM B OOK
EX

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 2. Put–Call Parity
The four instruments in a put-call parity are as follows:
• Asset: An asset such as a stock with no carrying costs and no interim cash flows. At
time 0, the price of the stock is S0.

I L . CO M
• Zero-coupon bond: A zero-coupon bond with a face value of X that matures at time

@ G
T. At time 0, the value of this bond is X/(1 + r)^T .
E MA
• Call option: A call option onK S F I ANC
Nwith a strike price of X that expires at time T.
B O O the stock
E XAMprice at expiration T.
ST is the underlying
• Put option: A put option on the stock with a strike price of X that expires at time T.

Note: The strike price, X, of the options is the same as the par value of the bond.

According to put-call parity, fiduciary call = protective put.

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 2.1 Protective Put
A protective put is to buy the underlying and buy a put option on it. The cost of this
strategy is:
p0 + S0

I L . C O M
A protective put is like buying insurance for an asset you own, specifically a stock, to
protect against a downside.
E @ G MA
For instance, you own 1,000 sharesFofIN A C market is highly volatile and you are
Nthe
O O K S Apple,
M B
EXA
worried about a huge decline in the near term.

To limit the downside risk, you can buy a put option on the stock by paying a
premium. This is called a protective put.

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 2.1 Protective Put

L . CO M
E @ G MAI
SFI N ANC
AM B OOK
EX
Interpretation:
As you can see, the downside risk is limited to the premium paid for the put. If the underlying price falls
below X, it can be still be sold at X by exercising the put option.
If the underlying rises above X, then it can be sold at the market price and the put option expires
worthless.

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 2.2 Fiduciary Call
A fiduciary call is a long call plus a risk-free bond. The cost of this strategy is:
X
c0+
1+r T

The diagram below shows the payoff for a fiduciary call:

L . CO M
E @ G MAI
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AM B OOK
EX

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 2.2 Fiduciary Call
Therefore, according to put-call parity:
X
C0 + = p0 + S0
1+r T

In other words, under put–call parity, at t = 0 the price of the long callO
I L . C M
plus the risk-
free asset must equal the price of the long underlying G
@ A
Mplus the long put.
A N C E asset

K SFI N
M B O O
EX A

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 2.2 Fiduciary Call
The table below shows how the fiduciary call is equal to the protective put under two
possible scenarios: when the stock is above the exercise price (call is in the money)
and the stock is below the exercise price (put is in the money).

Outcome at time T when: → Put expires in the money (ST < X) Call expires in the money (ST > = X)
L . CO M
E @ G MAI
SANC
Protective put
Asset
N
KSFI X-S
ST
O
T

B O
XAM
Long puts T 0
Total
E X ST

Fiduciary call
Long call 0 ST – X
Risk-free bond X X
Total X ST

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 2.2 Fiduciary Call
Fiduciary Call Protective Put
Constituents Long call + risk-free Long put + stock
bond
Equation c0+
X p0+S0
1+r T

I L . CO M
A
Payoff at T if call expires in the money (ST > = X) ST ST
E @ G M
Payoff at T if put expires in the money
N A N C X X
(ST < X)
O O K SFI
E AMB
X
If, at time 0, the fiduciary call is not priced the same as the protective put, then there
is an arbitrage opportunity.

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 2.3 Example: Put-Call Parity
A stock currently trades at INR295 per share. An investor is considering the purchase
of a six-month put on this stock at an exercise price of INR265. A six-month call option
with the same exercise price trades in the market at INR59. What should the investor
expect to pay for the put if the relevant risk-free rate is 4%?

L . CO M
E @ G MAI
Solution:
SFI N ANC
B O O K
A M
According to put call
EX
parity:
X 265
c0+ = p0 + S0 59 + = p0 + 295 59 + 259.85 = p0 + 295
1+r T 1+0.04 0.5

p0 = INR23.85
The investor should expect to pay a six-month put option premium of p0 = INR23.85

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 3. Option Strategies Based on Put–Call Parity
The put-call parity relationship can be rearranged in the following ways:
X X
Synthetic call: c0 = p0 + S0 – Synthetic bond: = p0 + S0 – c0
1+r T 1+r T

Synthetic put: p0 = c0+ COM

X X
Synthetic stock: S0 = c0+ – p0
A I L . - S0
@GM
1+r T 1+r T

A N C E
K S F I N
M B O O
These equations allow us to replicate an instrument by using the other three
E X
instruments. For A
example, a put option can be replicated by a combination of a long
call, a long risk-free bond and a short position in the underlying.

We can also compare the price of an actual instrument to its synthetic version. If the
two prices are different, we can generate riskless profits by exploiting the mispricing.

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4. Put–Call Forward Parity and Option Applications
In earlier readings we saw that:

Long asset + Short forward = Long risk-free bond

i.e. Asset – Forward = Risk-free Bond
(Long positions are shown as +ve and short positions as -ve) L.COM
M A I
A N C E@G
Rearranging, we get:
KSFI N
M B O O
E X A
Asset = Forward + Risk-free bond

We will use this relationship to come up with the put-call forward parity.

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 5. Put–Call Forward Parity
Protective put: Asset + Put
If we substitute the ‘asset’ part in a protective put with a forward and risk-free bond
we get:
Synthetic protective put = Forward + Risk-free bond + Put
Here, the risk-free bond has a par value equal to the forward price of O
I L . C M
F0 (T).
@ G M A
The cost this synthetic protective put is:
A N C E
K S F I NF T
O
o

A M B O 0 + + p0
X (1 + r) T
E
The cost of entering a forward contract at t=0 is zero as it requires no upfront
payment.
Fo T
The risk-free bond with par value F0 (T) can be purchased at t=0 for
(1+r)T
The put option premium at t=0 is p0
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 5. Put–Call Forward Parity
The table below shows that the payoff for a protective put with an asset and a synthetic protective put
with a forward contract is the same when the put expires in and out of the money.
Outcome at T
Put Expires In the Money (𝐒𝐓 < 𝑋) Put Expires Out of the Money (𝐒𝐓 ≥ 𝐗)
Protective put with asset
Asset ST
L . CO M ST

MAI
Long put X - ST 0

E @ G
ANC
Total X ST
Protective put with forward contract
K SFI N
Risk-free bond
M B O O F o (𝑇) Fo (𝑇)

EX
Forward contract A ST − Fo (𝑇) ST − Fo (𝑇)
Long put X - ST 0
Total X ST
Interpretation:
• Value of the forward contract at expiration = ST – F0 (T).
• Notice that the value of the forward contract at expiration is the same irrespective of whether the
put expires in or out of the money.
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 5. Put–Call Forward Parity
The put-call parity relationship can now be written as:

Synthetic protective put = Fiduciary call

L . CO M
Long forward + Risk-free bond + Long Put
@ G = AI + Bond
MCall
ANC E
K SFI N
B T O
O
0 EX+AM o F
(1+r)T
+ p0 = c0 +
X
1+r T

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 5. Put–Call Forward Parity
The table below shows that the payoffs for fiduciary call is equal to synthetic protective put when call
and put expire in the money.
Outcome at T
Put Expires In the Money (𝐒𝐓 < 𝑋) Put Expires Out of the Money (𝐒𝐓 ≥ 𝐗)
Synthetic Protective Put
Fo (𝑇)
L . CO MFo (𝑇)
MAI
Risk-free bond
Forward contract ST − Fo (𝑇)
E @ G ST − Fo (𝑇)
Long put
SFI N X − ST
ANC 0
Total
AM B OOK X ST

Fiduciary call
EX
Call 0 ST − 𝑋
Risk-free bond X X
Total X ST

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6. Option Put–Call Parity Applications: Firm Value
The put-call parity relationship can also be used to model the value of a firm to equity
and debt holders.

Assume that at time t = 0, a firm with a market value of V0 has access to borrowed
capital in the form of zero-coupon debt with a face value of D.
L . CO M
The value of equity at t = 0 is E0.
E @ G MAI
S F I N ANC
B O O K
The firm value can be expressed as:
EX A M
V0 = E0 + PV(D)

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6. Option Put–Call Parity Applications: Firm Value
When the debt matures at T, there are two possible outcomes:

1. Solvency (VT > D): The firm value exceeds the face value of debt and we say that
the firm is solvent. In this case:
▪ Debtholders are paid in full and receive D.
L . CO M
▪ Shareholders receive the residual: ET = VT – D.@G
E MAI
A N C
O O K SFIN
B
AM In this case:
2. Insolvency (VT < D): The firm value is below the face value of debt and we say that
is X
the firm E insolvent.
▪ Debtholders have a priority claim on assets and receive VT (which is less than D).
▪ Shareholders don’t receive any funds, ET =0.

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6. Option Put–Call Parity Applications: Firm Value
Thus,
Shareholder payoff is max(0, VT – D) and
Debtholder payoff is min(VT, D).
These payoff profiles can be expressed in terms of options:
Shareholders hold a long position in the underlying firm’sA I L . C O M
•
E @ G M assets (VT) and have
ATNC
K S F I N
purchased a put option on firm value (V ) with an exercise price of D; that is, max(0,
D – VT).
M B O O
EX
Or we can
A
also say that shareholders have purchased a call option on the firm’s
assets with an exercise price of D.
• Debtholders hold a long position in a risk-free bond (D) and have sold a put option
to shareholders on firm value (VT) with an exercise price of D.

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6. Option Put–Call Parity Applications: Firm Value
Exhibit 9 from the curriculum shows the payoff profiles for shareholders and
debtholders.

L . CO M
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EX

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6. Option Put–Call Parity Applications: Firm Value
Revisiting the put-call parity relationship:

S0 + p0 = c0 + PV(X)

Replacing ‘S0’ with ‘V0’ and ‘X’ with ‘D’ we get:

L . CO M
V0 + p0 = c0 + PV(D)
E @ G MAI
SFI N ANC
OOK
V0 = c0 + PV(D) - p0
A M B
EXof the firm is the value to the shareholders (represented by the call
Thus, the value
option c0) plus the value to debt holders (represented by the risk-free debt and a sold
put option p0).

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 Summary
LO: Explain put–call parity for European options.

According to put-call parity:

Fiduciary call = Protective put.

Long call + Risk-free bond =

A I L.COM
Long put + Stock
M
A N C E@G
c0 +
KSFI
X
N = p0 + S0
B O O 1+r T

E XAM

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 Summary
LO. Explain put–call forward parity for European options.
According to put-call parity, since a fiduciary call = protective put, a fiduciary call must also be equal to
a synthetic protective created using a forward contract and a risk-free bond.

Fiduciary call =
O M
Synthetic protective put
L . C
Long call + Risk-free bond =
E @ G MAI
Long Put + Long forward + Risk-free bond

SF
X
I N AN= C p0 Fo T

OOK
c0 + + 0 +
1+r T (1+r)T

AM B
EXrelationship can also be applied to explain the value of a firm:
The put-call parity

V0 = c0 + PV(D) - p0

The value of the firm is the value to the shareholders (represented by the call option c0) plus the value
to debt holders (represented by the risk-free debt and a sold put option p0).

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