Option Replication Using Put-Call Parity Flashcards
How is a “Fiduciary Call” made?
Buy/Own:
- Long Call Option with Strike Price X
- $X of Risk-Free Bonds
How is a “Protective Put” made?
Buy/Own:
- Underlying Asset
- Put Option
What is the purpose of a “Protective Put”?
Downside Protection:
The primary benefit is downside protection. If the stock price falls below the strike price of the put, the investor can exercise the option, selling the stock at the strike price, regardless of how low the market price drops. This limits the investor’s potential loss to the difference between the stock’s initial price and the strike price of the put, minus the cost of the put option.
Draw the payoff diagram of a “Protective Put”
Draw the payoff diagram of a “Fiduciary Call”
What does “Put-Call Parity” ensure?
How does this impact market efficiencies?
A “Protective Put” should be equal to a “Fiduciary Call’
Ensures a no-arbitrage condition.
Does “Put-Call Parity” extend to both European and American options?
No. It only works for European options.
What is the “Put-Call Forward Parity”
Put–call forward parity extends the put–call parity relationship to forward contracts given the equivalence of an underlying asset position and a long forward contract plus a risk-free bond.
How is a “Synthetic Long Position” made?
Buy:
Long Forward at strike price $X
$X of Risk-Free bonds
What is “Insolvency”?
Refers to the condition in which firm value is below the face value of debt used to finance the firm’s assets.
