Question

a) 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

The two market frictions will be:

1. Transaction Costs- Sometimes the deviation is so less that when an arbitrageur goes to benefit from it, he/she will find that after transaction cost, no profit remains. Hence, transaction cost is an important factor.

2. Liquidity- Sometimes there is not enough liquidity in either the stocks or the call option to realize the price at which we want to buy in order to deviate from put-call parity and benefit from it. Hence, lack of liquidity is a market friction which has to be kept in mind.

answered by: anonymous