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The option trading in India is a new concept. Option trading started in India in July,
2001. Because of its mathematical nature not many investors deal in option
trading. Acc to the NSE 2009 estimate, only 2.02 % investors traded in stock
options. This project tries to investigate the put call parity relation for stock options
in Indian securities market. Using option price data we tried to analyze the put call
parity relation. The call and option prices for different stocks were taken from
National Stock Exchange of India. Corresponding stock prices were also noted
down. After collecting all the relevant data for put call parity relation, different
values were substituted in the inequality relation.
If the inequality was satisfied, it means parity relation holds, else does not. After
analyzing, the entire calculations, it was concluded that put call parity relation
holds for stock options as well. And market is efficient.
In case, where put call parity gets violated, and then arbitrage opportunities arises.
These arbitrageurs try to take advantage of the discrepancy in put call option prices
and thus earn profit over them.
Today, more and people have started dealing in stock options. No doubt, the market
has grown tremendously since its inception but still it will take some time these
stock options traders % to rise.
CONTENTS
ACKNOWLEDGEMENT
CHAPTER 1. INTRODUCTION
1.1 OPTIONS & TYPES OF OPTIONS
1.2 HISTORY OF OPTIONS
1.3 OPTIONS IN INDIA
1.4 PUT- CALL PARITY THEOREM
1.5 HISTORY OF PUT CALL PARITY
CHAPTER 4. CONCLUSION
4.1 CONCLUSION
BIBLIOGRAPHY
CHAPTER 1
INTRODUCTION
1.1 OPTIONS & TYPES OF OPTIONS:
Options are financial instruments that convey the right, but not the obligation, to engage in a
future transaction on some underlying asset or security, or in a futures contract. In return for
granting the option, the seller collects a payment called as premium, from the buyer. A call
option gives the buyer the right to buy the underlying asset whereas a put option gives the buyer
of the option the right to sell the underlying asset.
The call options give the owner or the investor the right to purchase 100 shares of stocks at the
strike prices until they expire. The call options provide the owner the same exposure to the stocks
as the owner of the shares, yet there will be downside limits. However, if the stocks fall
suddenly, the owner can lose most in a call option is their premium paid price for that failed
option. Then, the seller (also called writer) of call options has the possible unlimited losses.
If the stock price increases greatly and the option is then exercised, the 100 shares of stocks must
be delivered by the seller in exchange for the price (strike) per share. But if the option seller did
not own the stock already, this is being referred to as simply being naked; she or he must buy
now the stock at the current market price. The stock’s price increase indefinitely, this is why the
maximum loss theoretically of the option seller is also infinite. In general, the call options are
used by investors to be able to control such long position with just less capital, buy it creates a
greater risk of losses for the option seller.
The put option gives the owner or investor the right to put on sale 100 shares of stocks at the
latest strike price until it expires. The put options offer the owner the same exposure to the stocks
just like being short of the shares yet limits its downside. If the stock price increases drastically,
then the owner can lose only the amount that he or she has paid for that option. Some instances
of this option is a person who longs stocks can definitely purchase a put option as their hedge
against the fall or failure in the price of the stocks.
If the option price falls or decreases below the said strike price, these investors will then mitigate
his losses or her losses because a put option can be appreciated as the stocks depreciate.
However, at some point, hedges can be lifted. The investors will then return to being simply long
There are different styles of options as well in which they are executed. But two are most
commonly used.
1). European option: European options are options that can be exercised only on the expiration
date. All index options traded at NSE are European Options. Options contracts like futures are
Cash settled at NSE.
2). American option: - American options are options contracts that can be exercised at any time
up to the expiration date .Options on individual securities available at NSE are American type of
options.
Besides, the above mentioned two option styles, Bermudan, Barrier, Exotic & Vanilla options are
also there but they are not used so frequently.
Contracts similar to options are believed to have been used since ancient times. In the real estate
market, call options have long been used to assemble large parcels of land from separate
owners, e.g. a developer pays for the right to buy several adjacent plots, but is not obligated to
buy these plots and might not unless he can buy all the plots in the entire parcel. Film or
theatrical producers often buy the right — but not the obligation — to dramatize a specific book
or script. Line of credit gives the potential borrower the right — but not the obligation — to
borrow within a specified time period.
In London, puts and "refusals" (calls) first became well-known trading instruments in the 1690s
during the reign of William & Mary.
Privileges were options sold over the counter in nineteenth century America, with both puts and
calls on shares offered by specialized dealers. Their exercise price was fixed at a rounded-off
market price on the day or week that the option was bought, and the expiry date was generally
three months after purchase. They were not traded in secondary markets.
Supposedly the first option buyer in the world was the ancient Greek mathematician and
philosopher Thales. On a certain occasion, predicted that the season's olive harvest would be
larger than usual and during the off-season he acquired the right to use a number of olive presses
the following spring. When spring came and the olive harvest was larger than expected he
exercised his options and then rented the presses out at much higher price than he paid for his
'option'.
NSE introduces option strikes on a daily basis based on the price of the underlying asset. With
regard to options on stocks the Exchange provides a minimum of seven strike prices for every
option type (i.e Call & Put) during the trading month.
Put/call parity was developed by Stoll (1969) to establish a relationship between the prices of put
and call options. To begin understanding how the put-call parity is established, let's first take a
look at two portfolios, A and B. Portfolio A consists of a European call option and cash equal to
the number of shares covered by the call option multiplied by the call's striking price. Portfolio B
consists of a European put option and the underlying asset. Note that equity options are used in
this example.
If the two portfolios have the same expiration value, then they must have the same present value.
Otherwise, an arbitrage trader can go long on the undervalued portfolio and short the overvalued
portfolio to make a risk free profit on expiration day. Hence, taking into account the need to
calculate the present value of the cash component using a suitable risk-free interest rate, we have
the following price equality:
p + S = c + X exp(-rt)
where,
This relation holds for European options. However, the above equation does not hold for
American options.
In case of American options, the theorem modifies as,
Here, the difference of the call and put option value must lie within the difference of stock value
and present price and difference of stock value and present value of strike price.
As far as European & American options are concerned an American option is worth at least as
much as the corresponding European option.
i.e.
C≥ c
P≥ p
An American option can be exercised before expiration as well, however it is never optimal to
exercise early if a share stock pays no dividend. Thus two strategies may be followed,
1). Exercise the option early and thus profit on the option is equal to the difference of stock price
and strike price i.e. S-X.
2). The other can be to sell the option whereby the profit will be difference of stock and present
value of strike price with the time value i.e. S-X exp(-rt) + Time value.
But It is never optimal to exercise an American put just before a dividend payment.
An American option (a call, for instance) may have a positive payoff even when the
corresponding European call has zero payoff.
American options expire the third Saturday of every month. They are closed for trading the
Friday prior.
There are no general formulae for pricing American options, but choices of models to
approximate the price are available eg. Binomial pricing formula,Whaley & others.
USES OF PUT-CALL PARITY THEOREM:
1). In Islamic Finance:
The put-call parity is also used to avoid usury restrictions. Today, some Islamic scholars are
using put-call parity to avoid Islam’s prohibition on paying interest.
2). To synthesize ownership interests.
3). To transfer depreciation deductions.
METHODOLOGY
2.1 RATIONALE FOR STUDY
The put call parity basically exists for European options, however it was modified for American
options and hence bringing out the inequality signs in equation. This theorem is one of the
important and most used equations in finance. But as,
This is what William Gilbert said. Actually, it implies things are not always the same as they
appear, perception is always different from reality. Same is the case with the put-call parity
equation. So we tried to investigate this theorem for stocks in India.
SOURCE OF DATA:
The entire study is based on secondary source. All the call and put option prices along with stock
prices were collected from NSE website. Besides, journals available and some books were used
to collect the data.
.
2.4 METHODOLOGY:
We started our study by collecting option prices first of all from NSE site. The strike price was
fixed as 700 for the sake of convenience, after that all the companies for which the American call
option prices were available were noted. Corresponding put & underlying asset value were also
noted down.
The risk free rate of interest was again taken from NSE website. As it was for 91 day treasury
bill, it was annualized by multiplying by 4 & dividing by100.
For annualizing time period, first of all no. of days were found out between day on which the
option was issued & day on which it expired. The difference was divided by 365.
As evident from the equation, the value of C-P must lie within S-X & S-X exp (-rt) for parity to
be there.
So we used logical formula in MS excel and denoted result as
“parity” where it denotes the value was lying in between and hence the theorem was valid in this
case and
“no parity” where it denotes the value didn’t lie in between and theorem is not valid in this
particular case.
1. ABAN
2. ABB
3. ABIR
4. ACC
5. AUROPHARMA
6. AXIS BANK
7. BEML
8. BHUSAN STEEL
9. COLPAL
10. DR. REDDY
11. HIND ZINC
12. ICICI
13. MAHINDRA & MAHINDRA
14. PUNJAB NATIONAL BANK
15. RELIANCE CAPITAL
16. STER
17. TATA TEA
18. TECH MAHINDRA
19. TULIP
20. ULTRA CEMENT
CHAPTER 3
ANALYSIS
&
INTERPRETATIO
N
TABLE 1 DATA SHEET FOR ABAN
ABAN For ABAN, out of 34 cases in only 1 case the parity was not found.
ABB For ABB, in 8 cases the parity was not there out of 62 cases.
ABIR For all 35 trading days parity exists.
ACC For all 62 trading days parity exists.
AIRTEL For AIRTEL, the data was available for only 8 days and parity existed
for all 8 trading days.
AURO For AURO PHARMA, again the data was available for 17 days and
PHARMA parity existed for all 17 days.
AXIS Parity exists for all 61 trading days for which data was available.
BEML Parity exists for all 62 trading days for BEML.
BHSN For BHSN STEEL, the parity was not there in only one case out of 62
trading days.
COLPAL Parity exists in all 34 cases where data was available.
Dr. Out of 62 trading days, in 7 cases the parity was not found.
REDDY
HIND Parity exists for all 60 trading days.
ZINC
ICICI In case of ICICI out of 62 trading days parity didn’t existed for 21 days
which is of course a considerable figure.
PNB Out of 62 trading days, for 18 cases parity was not found to be there.
M&M Out of 62 trading days, parity was not found on four days.
REL Data available was only for 34 trading days and parity didn’t existed in
CAPTL only 3 cases.
TULIP Parity existed for all 62 trading days.
ULTRA Out of 62 trading days, parity was not found to be there in one case that
CEM of course can be neglected.
In all the above cases the parity was not there in the last case. i.e. the options that expire on 27 th
Aug. It is evident as the value of call and put options on the last day is zero. So we haven’t
included this in any of the above cases.
INTERPRETATION:
The above results clearly show that parity exists in put call prices of the options. However, in
some cases parity was not found to be there but the no. of such cases was of course negligible.
Still, on observing such cases, three factors were found that may have affected the equation.
1).TIME:
In general. it was found that as maturity period draws nearer, the parity was not there. This may
be due to the fact also the value of an option declines more rapidly as the option approaches the
expiration day.
Arbitrage is a strategy where investors earn profit with out making an initial investment. For the
arbitrageur to obtain an arbitrage profit, the present stock price must be sufficiently higher than
the implied stock price to cover the cost of short selling in every future state. Arbitrage strategies
are not a useful source of profits for the average trader, but knowing how synthetic relationships
work can help us understand options better. In the options market, arbitrage trades are often
performed by firm or floor traders to earn small profits with little or no risk.
To setup an arbitrage, the options trader would go long on an underpriced position and sell the
equivalent overpriced position. If puts are overpriced relative to calls, the arbitrager would sell a
naked put and offset it by buying a Synthetic put.
Similarly, when calls are overpriced in relation to puts, one would sell a naked call and buy
a Synthetic call
However, an important lesson to learn from here is that the actions by floor traders doing
reversals and conversions quickly restore the market to equilibrium, keeping the price of calls
and puts in line, establishing the parity in call & put prices.
A conversion involves buying the underlying stock while simultaneously buying a put and
selling a call.
For a reverse conversion we short the underlying stock while simultaneously selling a put and
buying a call.
3.3 LIMITATIONS:
1. As the strike price was chosen to be 700 for all the companies, data was available only
for 22 companies in the given range.
2. Due to non-availability of data sample size was very small.
3. Due to paucity options with varying prices could not be taken.
4. Analysis has been done without taking into account transaction cost.
CHAPTER 4
CONCLUSION
CONCLUSION:
The put/call parity theory was developed to link the prices of calls and puts through the price of
the underlying stock, an appropriate interest rate, and the time to maturity of the options. This
equation is one of the important equations today used in finance. However, option market is not
yet so developed in our country. Many investors are not even aware of option trading. Acc to
product-wise no. of contracts traded during 2008-09, stock options constitute only 2.02% of the
entire market. In fact, due to its mathematical nature many people finds it difficult to understand
option trading.
But due to flexibility involved in option trading where we can not only reduce but transfer our
risk as well to other person more and more people have started trading in options. Since its
inception in July 2001, the option market has grown tremendously.
The put call parity theory helps the investors to analyze properly and then to decide over what
option he should buy & what options to sell on.
Put call parity holds for Indian stocks that shows that the market is efficient.
The magnitude of violations of put call parity is very small. Out of 1014 cases for which
put call parity calculations were done, violation was there only in 72 cases i.e. 7.10 %,
which can be neglected.
On the whole it can be concluded that put call parity theorem holds in Indian context.
Whatever deviations may found may disappear once transaction cost is taken into
account.
BIBLIOGRAPHY
Shapiro, Alan, C., Multinational Financial Management, 8th ed. Wiley
Hull, J.C., options, futures and other derivatives. New Delhi: PHI, 2007
Sharpe, William, Gordon Alexander and Jeffrey V. Bailey, Investments, fifth edition, Prentice
Hall
Weiyu Guo, Tie Su, “Option Put-Call Parity Relations” International Journal of Business
and Economics, 2006, Vol. 5, No. 3, 225-230
Amin. K. I. and C.M.C. Lee 1997, “option trading discovery. And earning news dissemination.”
Contemporary accounting Research. 14. 153. 192
WEB REFERNCES
www.nseindia.com
www.investopedia.com
www.yahoofinance.com
www.scribd.com
www.OPTIONTRADINGpedia.com
www.optionguides.com
SEARCH ENGINES
GOOGLE.
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