What is Put-Call Parity?

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The term "put-call" parity refers to a principle that defines the relationship between the price of European put and call options of the same class. Put simply, this concept highlights the consistencies of these same classes. Put and call options must have the same underlying asset, strike price, and expiration date in order to be in the same class. The put-call parity, which only applies to European options, can be determined by a set equation.

Definition

Put-Call Parity is a principle that defines the price relationship between European put and call options of the same class. Simply put, this concept highlights the consistency within these same categories. Put and call options must have the same underlying asset, strike price, and expiration date to belong to the same class. Applicable only to European options, Put-Call Parity can be determined through a fixed equation.

Origin

The concept of Put-Call Parity originated from the development of option pricing theory, particularly during the rapid expansion of the options market in the 1970s. This principle helps investors understand and exploit arbitrage opportunities in the options market.

Categories and Features

Put-Call Parity mainly applies to European options, which can only be exercised on the expiration date. It is characterized by the formula C + PV(X) = P + S, where C is the call option price, P is the put option price, PV(X) is the present value of the strike price, and S is the current price of the underlying asset. This formula helps investors conduct arbitrage trading in the options market.

Case Studies

Case 1: Suppose a company's stock is currently priced at $100, with a call option priced at $10 and a put option priced at $8, both with a strike price of $100. Using the Put-Call Parity formula, investors can verify whether these options are priced correctly. Case 2: During the 2008 financial crisis, many investors used the Put-Call Parity principle to hedge market risks, ensuring their portfolios remained stable amid market volatility.

Common Issues

Investors often misunderstand that Put-Call Parity applies to all types of options, whereas it actually only applies to European options. Additionally, ignoring market volatility and interest rate changes can lead to incorrect arbitrage decisions.

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