Question

1. It has been observed that the put-call parity relation is often violated in practice – that is, Put price > Synthetic put price = Call price + Present value of strike price –Underlying stock price + Present value of dividends. In other words, if one buys the synthetic put by buying call, buying a risk-less bond that pays the strike price at the maturity, and short-selling the underlying stock and sells the put with the same strike price as the call option, she can make an arbitrage profit.

   Name TWO market frictions that would limit arbitrageurs from profiting from put-call parity violations and briefly explain.

Answer 1

Two market frictions that would limit arbitrageurs from profiting from put-call parity violations are :

1. Short sale restrictions - Certain financial markets place restrictions on short-selling. These restrictions could be in the form of temporary restrictions (such as market-wide position limits) or longer-term restrictions (short-selling not allowed on delivery basis but only intraday basis). This restriction would prevent arbitrageurs from exploiting the put-call arbitrage because the synthetic put cannot be bought.
2. Transaction costs - Due to prohibitive transaction costs, the put-call parity arbitrage may exist only on paper. Actually implementing the arbitrage opportunity may not be viable due to high transaction costs.