Question

Describe arbitrage strategy based on put-call parity.

Answer 1

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As per put-call parity (PCP)

P+ S = present value of X + C

P= value of put option.

S= current price of the share

X= strike price

C= value of call option. (PCP Call)

Present value of X = X/(1+r)

r = risk free rate.

If there is a mismatch between P & C, then put-call parity does not hold good.

We need to take benefit of this situation by conducting an arbitrage position.

Compare the value of Actual Call price in the market with that of PCP Call price.

If Actual Call< PCP Call then,

Arbitrage Strategy:

1. Buy Call.

2. Buy Risk-free Asset.

3. Sell Put.

4. Sell Stock.

If Actual Call> PCP Call then,

Arbitrage Strategy:

1. Sell Call.

2. Sell Risk-free Asset.

3. Buy Put.

4. Buy Stock.

Arbitrage profit = difference between Actual Call price in the market and PCP Call price.

= Actual Price- PCP Price.