Option Pricing Formulas Derivations

Ramesh Kadambi
March 20, 2013
2
Contents
0.1 The Black Scholes Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
0.1.1 CAPM Derivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
0.2 Modeling Futures Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
0.2.1 Futures Price Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
0.3 Options On Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
0.3.1 Blacks Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
0.3.2 Margined options on Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
0.3.3 Formula Derivation MOF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
0.3.4 Cash Settled Option Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
0.4 Currency Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
0.4.1 Modeling Currency Price Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
0.4.2 Call Option Price and PDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
0.5 Parities and Symmetries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
0.5.1 Put Call Parity Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
0.5.2 Put Call Parity Option Paying Dividend Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
0.5.3 PCP Option on Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
0.5.4 PCP Margined Options On Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3
4 CONTENTS
0.1 The Black Scholes Formula
In this section we derive the Black Scholes formula for pricing
vanilla european options. The following is similar to the deriva-
tion of BS from the original paper
1
. The formula assumes the
following as stated in the original paper:
1. The short-term interest rate is known and is constant
through time.
2. The stock price follows a random walk in continuous time
with a variance rate proportional to the square of the
stock price. Thus the distribution of possible stock prices
at the end of any nite interval is log- normal. The vari-
ance rate of the return on the stock is constant.
3. The stock pays no dividends or other distributions.
4. The option is European, that is, it can only be exercised
at maturity.
5. There are no transaction costs in buying or selling the
stock or the option.
6. It is possible to borrow any fraction of the price of a se-
curity to buy it or to hold it, at the short-term interest
rate.
7. There are no penalties to short selling. A seller who does
not own a security will simply accept the price of the secu-
rity from a buyer, and will agree to settle with the buyer
on some future date by paying him an amount equal to
the price of the security on that date.
The idea is to form a risk-less position using the option and the
stock. We create the following portfolio.
1. Long one stock.
2. Short
1
Cs(S,t)
option on the stock at strike K and expira-
tion T.
Where S(t) is the price of the stock, C(S, t) is the value of the
option.
We note that the change in value of the portfolio is 0 for
small changes in the value of the stock price. If the stock price
changes by a value dS the value of the portfolio (C, S, t) is
given by.
d(C, S, t) = dS(t)
1
C
s
(S, t)
dC(S, t)
Using rst order approximation we have
dC(S, t) = C
s
(S, t)dS(t)
2
d(C, S, t) = dS(t)
1
C
s
(S, t)
C
s
(S, t)dS(t) = 0
Quoting from the original paper again:
As the variables S(t) and t change, the number of options
to be sold short to create a hedged position with one share of
stock changes. If the hedge is maintained continuously, then
the approximations mentioned above become exact, and the
return on the hedged position is completely independent of the
change in the value of the stock. In fact, the return on the
hedged position becomes certain.
The hedged portfolio is risk-less and grows at a risk-free rate.
The original paper contends that in the absence of continuous
hedging the risk can be diversied away and the risk is mainly
due to the fact that the hedge is not continuously adjusted.
Substituting for dC(S, t) using Itos lemma we get the fol-
lowing.
dC(S, t) = C
t
dt +C
s
(S, t)dS +
1
2
C
ss
dS
2
substituting into equation (1) we have
d(S, t) = dS(t)
1
C
s
(S, t)
[C
t
dt +C
s
(S, t)dS +
1
2
C
ss
dS
2
]
d(S, t) =
1
C
s
(S, t)
[C
t
dt +
1
2
C
ss
dS
2
]
r(S(t)
1
C
s
(S, t)
C(S, t))dt =
1
C
s
(S, t)
[C
t
dt +
1
2
C
ss
dS
2
]
r(C
s
S(t) C(S, t))dt = dt[C
t
+
1
2

2
S
2
C
ss
]
canceling dt and rearranging terms
C
t
+
1
2

2
S
2
C
ss
+rSC
s
rC = 0 (0.1.1)
The boundary conditions to the BS equation:
C(S, T) = (S(T) K)
+
C(S
max
, t) = S(t) Ke
r(Tt)
C(S
min
, t) = 0
The analytical solution the PDE given BCs
C(S, t) = S(t)N(d
1
) Ke
r(Tt)
N(d2)
where
d
1
=
ln(F/K) +
1
2

2
(T t)

T t
d
2
= d
1

T t
0.1.1 CAPM Derivation
CAPM relates the excess returns of a security to excess return
on the market portfolio. The CAPM equation is given by
E[r
i
] r
f

i
= E[r
m
] r
f
1
Pricing of Options and Corporate Liabilities, Fischer Black, Myron Scholes
2
Note this is not applying Itos lemma on C(S, t) which it really should. It so happens it works out ne if you do so.
0.2. MODELING FUTURES DYNAMICS 5
. Considering the option as a investment security we have the
following for the option excess returns.
E[r
c
] = r
f
+
f
(E[r
m
] r
f
)
Similarly for the stock we have.
E[r
s
] = r
f
+
s
(E[r
m
] r
f
)
The question now is how are the beta of the option and
the beta of the stock related. From the relation dC(S, t) =
C
t
dt +C
s
dS +
Css
2
dS
2
we have.
dC
C
=
1
C
[C
t
+
1
2

2
S
2
]dt| +
C
s
C
dS
denoting the return on the stock as r
s
we have
dC
C
=
1
C
[C
t
+
1
2

2
S
2
]dt| +
SC
s
C
r
s
r
C
=
1
C
[C
t
+
1
2

2
S
2
]dt| +
SC
s
C
r
s
(0.1.2)
The beta of the option is given by
Cov(rc,rm)
var(rm)
. Using (0.1.2) we
can show that
C
=
S
CsS
C
. Now we have the following two
equations from CAPM model.
E[
dC
C
] = (r
f
+ (E[r
m
] r
f
)
C
)dt (0.1.3)
E[
dS
S
] = (r
f
+ (E[r
m
] r
f
)
S
)dt
multiplying (0.1.3) by C and substituting for
C
we have
E[dC] = (r
f
C + (E[r
m
] r
f
)
S
SC
s
)dt
substituting for dC using itos lemma and
simplifying yields (0.1.1)
0.2 Modeling Futures Dynamics
A futures contract is an exchange listed product that settles all
cash-ows at the end of the day. The value of the contract at
expiration is the value of the underlying at expiration. Con-
sider a time [0,T] which are divided into distinct time points
0 = t
0
< t
1
< t
2
< t
3
< t
4
... < t
n
= T. The futures settles at
times t
k
{t
1
, t
2
, , t
n
} by paying Fut
s
(t
k+1
) Fut
s
(t
k
, T).
We show here that futures price is a martingale and propose a
price for an option on Future. Consider the sum of payments
from holding a futures contract from [t
0
, T].
Fut
s
(t
1
, T) Fut
s
(t, T) + +Fut
s
(T, T) Fut
s
(T 1, T)
= S(T) Fut
s
(t, T)
The futures price process by construction is a F(t) measur-
able martingale. Let Fut
s
(t, T) be the price of a futures con-
tract at time t {t
0
, t
1
}. Since the payout as we saw earlier
Fut
s
(T, T) Fut
s
(t
0
, T) we have for the price of the future:
Fut
s
(t, T) = E[D(t)(Fut
s
(T, T) Fut
s
(t, T))|F(t)]
but Fut
s
(t, T) = 0
E[D(t)(Fut
s
(T, T) Fut
s
(t, T))|F(t)] = 0
Fut
s
(t, T) = E[Fut
s
(T, T)|F(t)]
= E[S(T)|F(t)]
0.2.1 Futures Price Process
Given the underlying price process once can determine the dy-
namics of the futures prices process given that it is a martingale.
Let dS = rSdt +SdW and F(t) the ltration for the B.M W.
We have:
Fut
s
(t, T) = E[S(T)|F(t)]
= S(t)e
r(Tt)
dFut
s
(t, T) = rS(t)e
r(Tt)
dt +e
r(Tt)
dS(t)
dFut
s
(t, T) = e
r(Tt)
S(t)dW(t)
= Fut
s
(t, T)dW(t)
0.3 Options On Futures
Consider an option on a future paying C(Fut
s
(t, T), t) at time
T. We can use the same hedging argument we used to obtain
the price of the option. We will however proceed using he mar-
tingale approach. We assume there exists a martingale measure
P. Since all processes grow at risk free rate under martingale
measure. We have using Itos lemma:
dC(Fut
s
(t, T), t) = C
t
dt +C
F
dFut
s
(t, T) +
1
2
C
FF
dFut
s
(t, T)
2
= C
t
dt +C
F
Fut
s
(t, T)dW(t) +

2
2
C
FF
Fut
s
(t, T)
2
dt
= (C
t
+

2
2
C
FF
Fut
s
(t, T)
2
)dt +C
F
Fut
s
(t, T)dW(t)
since the drift of all price processes under P is rPdt we have
(C
t
+

2
2
C
FF
Fut
s
(t, T)
2
)dt = rCdt
C
t
+

2
2
C
FF
Fut
s
(t, T)
2
rC = 0
6 CONTENTS
0.3.1 Blacks Formula
Consider a call option on a future paying (Fut
s
(T, T) K)
+
at
time T. The price of the option is given by the formula.
C(Fut
s
, t) = e
r(Tt)
(Fut
s
(t, T)N(d
1
) KN(d
2
))
where:
d
1
=
ln(Fut
s
(t, T)/K) +

2
2
(T t)

T t
d
2
= d
1

T t
The above formula is the result of the following calculation:
Consider the process ln(Fut
s
(t, T)) we have dln(Fut
s
(t, T))
dln(Fut
s
(t, T)) =

2
s
2
dt +
s
dW(t)
ln(Fut
s
(T, T)) = ln(Fut
s
(t
0
, T))

2
s
2
dt +
s
dW(t)
let Z(T,t) =
T

2
s
2
dt +
T

s
dW(t) then Z is a normal Random
variable N(

2
s
(Tt)
2
,
2
s
(T t))
E[e
rt
C(Fut
s
, t)|F(t)] = E[e
rT
(Fut
s
(T) K)
+
|F(t)]
C(Fut
s
, t) = e
rt
E[e
rT
(Fut
s
(T) K)
+
|F(t)]
C(Fut
s
, t) = e
rt
E[e
rT
(e
ln(Futs(t)+Z(T,t)
K)
+
|F(t)]
= e
rt
E[e
rT
(Fut
s
(t)e
Z(T,t)
K)
+
|F(t)]
= e
rt

I
{Futs(t)e
Z(T,t)
K}
e
rT
(Fut
s
(t)e
Z(T,t)
K)e

(Z+

2
s
(Tt)
2
)
2
2
2
s
(Tt)
dZ
= e
r(Tt)

I
{Futs(t)e
Z(T,t)
K}
Fut
s
(t)e
Z(T,t)
e

(Z+

2
s
(Tt)
2
)
2
2
2
s
(Tt)
dZ
e
r(Tt)

I
{Futs(t)e
Z(T,t)
K}
Ke

(Z+

2
s
(Tt)
2
)
2
2
2
s
(Tt)
dZ
consider

I
{Futs(t)e
Z(T,t)
K}
Fut
s
(t)e
Z(T,t)
e

(Z+

2
s
(Tt)
2
)
2
2
2
(Tt)
dZ we
will complete the squares to compute integral.
Z(T, t)
(Z +

2
s
(Tt)
2
)
2
2
2
s
(T t)
=
2
2
s
(T t)Z (Z +

2
s
(Tt)
2
)
2
2
2
s
(T t)
=
2
2
s
(T t)Z Z
2

2
s
(T t)Z (

2
s
(Tt)
2
)
2
2
2
s
(T t)
=
(Z

2
s
(Tt)
2
)
2
2
2
s
(T t)

I
{Futs(t)e
Z(T,t)
K}
Fut
s
(t)e
Z(T,t)
e

(Z+

2
s
(Tt)
2
)
2
2
2
s
(Tt)
dZ
=

I
{Futs(t)e
Z(T,t)
K}
Fut
s
(t)e
(Z

2
s
(Tt)
2
)
2
2
2
s
(Tt)
dZ (0.3.1)
dene a variable Y =
Z

2
s
(Tt)
2

2
s
(Tt)
, Y is a normally distributed
variable N(0,1).
Fut
s
(t)e
Z(T,t)
K
Z(T, t) ln(
K
Fut
s
(t)
)
Y
ln(
K
Futs(t)
)

2
s
(Tt)
2

2
s
(T t)
substituting the transformations into (0.3.1)

I
{Futs(t)e
Z(T,t)
K}
Fut
s
(t)e
(Z

2
s
(Tt)
2
)
2
2
2
s
(Tt)
dZ
=

Y
ln(
K
Futs(t)
)

2
s
(Tt)
2

2
s
(Tt)

Fut
s
(t)e
Y
2
/2
dY
=

Y
ln(
Futs(t)
)+

2
s
(Tt)
2

2
s
(Tt)

Fut
s
(t)e
Y
2
/2
dY
= Fut
s
(t)N(d
1
)
0.4. CURRENCY OPTIONS 7
where d
1
= ln(
Futs(t)
K
) +

2
s
(Tt)
2

2
s
(T t), we also have

I
{Futs(t)e
Z(T,t)
K}
Ke

(Z+

2
s
(Tt)
2
)
2
2
2
s
(Tt)
dZ (0.3.2)
dene a new variable Y
2
=
Z+

2
s
(Tt)
2

2
s
(Tt)
, we then have.
Fut
s
(t)e
Z(T,t)
K
Z(T, t) ln(
K
Fut
s
(t)
)
Y
2

ln(
K
Futs(t)
) +

2
s
(Tt)
2

2
s
(T t)
rewriting (0.3.2) in terms of Y
2
we have

I
{Futs(t)e
Z(T,t)
K}
Ke

(Z+

2
s
(Tt)
2
)
2
2
2
s
(Tt)
dZ
=

I
{Y
2

ln(
K
Futs(t)
)+

2
s
(Tt)
2

2
s
(Tt)
}
Ke
Y
2
2
2
dY
2
=

I
{Y
2

ln(
K
Futs(t)
)

2
s
(Tt)
2

2
s
(Tt)
}
Ke
Y
2
2
2
dY
2
=

I
{Y
2

ln(
Futs(t)
K
)

2
s
(Tt)
2

2
s
(Tt)
}
Ke
Y
2
2
2
dY
2
= KN(d
2
)
where d
2
=
ln(
Futs(t)
K
)

2
s
(Tt)
2

2
s
(Tt)
. Putting it all together we have
the price of the option on a future is:
C(Fut
s
(t), K) = e
r(Tt)
[Fut
s
(t)N(d
1
) KN(d
2
)]
where d
1
=
ln(
Futs(t)
K
)+

2
s
(Tt)
2

2
s
(Tt)
and d
2
=
ln(
Futs(t)
K
)

2
s
(Tt)
2

2
s
(Tt)
.
0.3.2 Margined options on Futures
The margined options on futures are traded on Sydney futures
exchange. The option premium is not exchanged at the time
of purchase i.e. The options contract works very similar to the
futures contract. The option premium is cash settled. The dif-
ference in the premium is either credited (debited) based on the
option price moving up (down). Upon expiration no money is
exchanged either. Given times t, t
1
, , t
T
. The pay out on a
cash settled Options contract is as follows.
C(F
t1
, t
1
) C(F
t
, t) + +C(F
T
, T) C(F
T1
, T 1)
= C(F
T
, T) C(F
t
, t) (0.3.3)
As seen in (0.3.3) we see that the nal payout is the value of
the option at time T minus the initial premium. As in the case
of the future price we set the expected value of the premium
dierence to be zero. We have:
E[D(t)(C(F
T
, T) C(F
t
, t))|F
t
] = 0
C(F
t
, t) = E[C(F
T
, T)|F
t
]
Given that the option price by design is a martingale w/o dis-
counting we obtian the PDE of the option as.
C
t
+

2
2
C
FF
Fut
s
(t, T)
2
= 0
0.3.3 Formula Derivation MOF
Using the previous denitions for Z, F we have.
C(F, t) = E[C(F
T
, T)|F
t
]
=

I
{F
T
K}
(F
T
K)p(F, T : f, t)dp
=

I
{e
Z
K}
(F
s
(t)e
Z
K)e

(Z+

2
s
(Tt)
2
)
2
2
2
s
(Tt)
dZ
This is the same as what we had when we solved for the futures
options. There fore we have from (0.3.1).
C(Fut
s
(t), K) = Fut
s
(t)N(d
1
) KN(d
2
)
0.3.4 Cash Settled Option Dynamics
As we saw the Cash Settled Option Process is a martingale. The
option price process is a function of the Futures price C(F
T
, T).
Applying itos lemma to C(F
T
, T) we have:
dC(F
T
, t) =

C
t
+

2
2
C
FF
Fut
s
(t, T)
2

dt +
f
F(T, t)dW(t)
Using the fact that the drift is zero we have:
dC(F
T
, t) =
f
C
F
F(T, t)dW(t)
0.4 Currency Options
Currency Options are priced using a modied version of BSPM.
The model is similar to pricing stock options paying dividend
yield. Quoting Bjork
3
: When we buy a foreign currency (say
US Dollars) we will not just keep the physical bills until we
sell them. Instead we typically put the dollars into an account
where they will grow at a certain rate of interest. This implies
3
Arbitrage Theory in Continuous Time, Thomas Bjork
8 CONTENTS
that the currency options can be modeled like an option on
stock that pays a dividend yield. Mathematically, the currency
option pricing involves two dierent measures. A foreign RNM
P
f
, and a domestic RNM P
d
. When we priced options on stock
we did so in the domestic RNM. In this section we will look
at the dierent prices processes and the dierent option pricing
formulas.
0.4.1 Modeling Currency Price Dynamics
We take as given the following dynamics for the the spot ex-
change rate X(t) quoted as
units of domestic currency
units of foreign currency
. We consider
as given a risk free domestic rate r
d
and a foreign rate r
f
. Cor-
responding to the risk free rates we have B
d
and B
f
as risk
free assets. We there fore assume the following dynamics for
the spot rate X(t) and the risk free assets under the physical
measure P.
dX = X
x
dt +X
x
d

W
dB
d
= r
d
B
d
dt
dB
f
= r
f
B
f
dt
Our objective is to price a pay-o of the type f(X(T)). We
make the assumption that all foreign assets are invested at the
risk-free foreign rate of r
f
. We have the price of the security
given as,
X
t
= e
r
d
(Tt)
E
Q
[f(X(T))|F
t
]
. Where Q is the RNM under domestic currency rate r
d
. Under
this measure all domestic assets have RND r
d
. Our next goal
is to translate the investment B
f
into domestic currency. Con-
sider the value of the foreign risk free asset in domestic terms,
we have.

B
f
(t) = B
f
(t)X(t)
d

B
f
(t) = dB
f
(t)X(t) +B
f
(t)dX(t) +dB
f
(t)dX(t)
d

B
f
(t) = r
f
X(t)B
f
dt +B
f
(t)[
x
X(t)dt +
x
X(t)d

W
d

B
f
(t) = (r
f
+
x
)

B
f
(t)dt +
x

B
f
(t)d

W (0.4.1)
We apply grisanovs theorem and a change of measure to move
to domestic RNM.
d

W = dW (t)dt
substituting into (0.4.1) we have,
d

B
f
(t) = r
d

B
f
(t)dt +
x

B
f
dW
we also have X(t) =

B
f
B
f
, applying ito
dX(t) = X(r
d
r
f
)dt +X
x
dW (0.4.2)
0.4.2 Call Option Price and PDE
Proposition 0.4.1. (Pricing Formula) The arbitrage free price
f(t, X) for the T-claim Z = f(X(T)) is given by f(t, X) =
e
r
d
(Tt)
E
Q
[f(X(T)]. The Q-dynamics of X is given by
(0.4.2). The PDE for the pay o is given by:
f
t
+ (r
d
r
f
)Xf
x
+
1
2

2
x
X
2
f
xx
r
d
f = 0
subject to boundary condition:
f(T, x) = f(x)
The closed form solution to price a call option C(X, T) =
(X(T) K)
+
is given by.
C(X, t) = X(t)e
r
f
(Tt)
N(d
1
) Ke
r
d
(Tt)
N(d
2
)
where
d
1
=
ln(F)
K
+

2
2
(T t)

T t
F = X(t)e
(r
d
r
f
)(Tt)
d
2
= d
1

(T t)
0.5 Parities and Symmetries
In this section we will derive the dierent put-call symmetries
and parity relationships for options on dierent underlying.
0.5.1 Put Call Parity Stock Options
The put call parity comes from looking at the terminal pay
o of a forward and noting that at expiration a forward con-
tract can be constructed using a long call option and a short
put option. This relation is a pure arbitrage relationship. We
therefore have:
F(T) = C(T) P(T)
Under risk neutral valuation we can compute the forward price
F(t) by taking discounted expectations.
E[e
rT
F(T)|F
0
] = E[e
rT
(C(T) P(T))|F
0
]
substituting the value of the forward contract is
F(T) = S(T) K
e
rT
E[S(T) K|F
0
] = E[e
rT
(C(T) P(T))|F
0
]
E[e
rT
S(T)|F
0
] Ke
rT
] = C(0) P(0)
S(0) Ke
rT
= C(0) P(0)
for an time t the put call parity for stock options is
S(t) Ke
r(Tt)
= C(t) P(t)
0.5.2 Put Call Parity Option Paying Dividend
Yield
When an option pays a dividend yield the forward price is ob-
tained by the following arbitrage argument. The idea of a for-
ward contract is to deliver a unit of stock for a pre-agreed strike
price K. Given that the stock yields a dividend of q, we have
the following cash ows.
0.5. PARITIES AND SYMMETRIES 9
Table 1: Cash ow table
Time Bank Stock Portfolio Value
0 S
0
e
qT
S
0
e
qT
0
T S
0
e
qT
e
rT
+K S
T
K S
0
e
qT
e
rT
At time T the value of the portfolio is KS
0
e
qT
e
rT
. The
strike of the forward contract is the value that makes the for-
ward price zero. We therefore have, for the forward price.
K = S
0
e
(rq)T
Moving on to the put call parity. We have the same situation,
as before:
F(T) = C(T) P(T)
taking discounted expectations under RNM we have
e
r(Tt)
E[S(T) K|F
t
] = e
r(Tt)
E[C(T) P(T)|F
t
]
E[e
r(Tt)
S(T)|F
t
] Ke
r(Tt)
= C(t) P(t)
e
q(Tt)
S(t) Ke
r(Tt)
= C(t) P(t) (0.5.1)
Note that in (0.5.1), e
r(Tt)
E[S(T)|F
t
] = e
q(Tt)
S(t) since
e
(rq)(Tt)
S(t) is a martingale and not just discounted stock
price.
0.5.3 PCP Option on Futures
The put-call parity for options on futures give a strike K and
expiration T is given as follows. At time T we have.
C(T) P(T) = F(T) K
taking discounted expectation at time t we have.
E[e
rTt
(C(T) P(T))|F(t)] = E[e
r(Tt)
(F(T) K)|F(t)]
C(t) P(t) = e
r(Tt)
(E[F(T)|F(t)] K)
C(t) P(t) = e
r(Tt)
(F(t) K) (0.5.2)
Note that the fact that the future price is martingale:
E[F(T)|F(t)] = F(t), is used in (0.5.2).
0.5.4 PCP Margined Options On Futures
The put-call parity for margined options is arrived at using
the same principle as before. However, since margined option
prices are martingales we do not take discounted expectations.
We therefore have the following:
C(T) P(T) = F(T) K
e
r(Tt)
E[C(T) P(T)|F(t)] = e
r(Tt)
E[F(T) K|F(t)]
C(t) P(t) = F(t) K (0.5.3)
Note, since the price processes are martingales the discount fac-
tors cancel each other leaving us with (0.5.3).