Put and Call Options Arbitrage
Introduction
Arbitrage mostly refers to risk free profits as the parties don’t speculate on the market but bet on
the share mispricing in different markets. Buying and selling similar securities but with different
rates and in different markets and making risk free profits adds up to an arbitrage.
A call option is a financial agreement or contract to between the seller and a buyer of the options.
The buyer retains all the rights to buy the options but he owes no obligation to the seller to buy
the options at a specified period. Put options allows one to make a profit by selling a stock back
to the investor at a specified price and time period before a particular date.
One can exercise his right for the put option by buying the stock at $5 and selling it back at a
higher price. The arbitrage is the risk free arbitrage profit of 7% of 58 for the put option which is
$4.06 and 7% of 59 for the call option which is $4.13.
The PV (Present Value) for the shares after 58* 1^0.07 = 54 for the put option while the call
option 59*1^0.07 = 55. (Brealey, Myers & Allen, 2006)
Put and Call Options Arbitrage 2
To summarize, the rule of thumb for arbitrage is that buy call options if the actual price for the
future is greater than the future theoretical values or prices where as the put options should be
bought if the actual future values or prices are lower than the current theoretical future prices.
Reference
Brealey, R.A., Myers, S.C. and Allen, F. (2006) Principles of Corporate Finance, 8th Edition.
McGraw-Hill/Irwin.
