Chapter 10

REPLICATION, SYNTHETICS AND ARBITRAGE
CHAPTER 10
Chapter Objectives
This Chapter is designed to introduce the logic of synthetics and arbitrage.
On completion of this chapter you should have a good understanding of the put-call
parity relationship.
You should also be able to understand the importance of why equilibrium

relationships must hold and how arbitrage is possible when there is a disequilibrium.
CHAPTER 10: Replication, Synthetics and Arbitrage Copyright 2017 by McGraw-Hill Education (Malaysia) Sdn. Bhd.
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Replication and Synthetics
Options can be used to replicate the cash flows of an asset and thereby effectively
synthesize the asset.
There are six basic strategies:

Long stock Short stock
Long call Short call
Long put Short put
Two simplifying assumptions are made for these strategies:

Interest rates and the timing difference between cash outlays now and option exercise are
ignored.
The underlying asset, exercise price and maturity of both the calls and puts are the same.
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Two simplifying assumptions are made for these strategies:
Interest rates and the timing difference between cash outlays now and option exercise are
ignored.
The underlying asset, exercise price and maturity of both the calls and puts are the same.
Synthetic Long Stock Position

Suppose 30-day, RM 12.00 call and put on Maybank stock are priced at RM 0.20 and RM 0.15
respectively, then the strategy and payoff are as follows:
Strategy: (to replicate long stock position)

Long, RM 12.00, Maybank call @.20
Short, RM 12.00, Maybank put @ .15
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Using call and put options, a synthetic long stock position can be created by going long a call
option and shorting a put option of the same exercise price.
Suppose 30-day, RM 12.00 call and put on Maybank stock are priced at RM 0.20 and RM 0.15
respectively, then the strategy and payoff are as follows:
Strategy: (to replicate long stock position)
Long, RM 12.00, Maybank call @.20

Short, RM 12.00, Maybank put @ .15
Long Stock = Long Call + Short Put
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Long Stock = Long Call + Short Put
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Synthetic Short Stock Position
A synthetic short stock position can be created by going short the call and long the put option.
Continuing with previous Maybank example, The strategy to replicate short stock position would
be:
Short, RM 12.00, Maybank call @ .20

Long, RM 12.00, Maybank put @ .15
Short Stock = Long Put + Short Call
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Synthetic Short Stock Position
Short Stock = Long Put + Short Call
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Synthetic Long Call Position
The synthetic option position can be created by combining a position in the underlying stock/asset
with an option position.
Continuing with the example of Maybank stock and options, a synthetic long call position can be
created by going long the stock and going long an at-the-money put option. Strategy would be:
Long, Maybank stock @ RM 12.00

Long, RM 12.00, Maybank put @ .15
Long Call = Long Stock + Long Put
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Synthetic Long Call Position
Long Call = Long Stock + Long Put
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Synthetic Short Call Position
A synthetic short call position can be established by going short a stock and an at-the-money put.
Continuing with Maybank example, Strategy to replicate a short call position would be:
Short, Maybank stock @ RM 12.00

Short, RM 12.00 Maybank put @ .15
Short Call = Short Stock + Short Put
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Synthetic Short Call Position
Short Call = Short Stock + Short Put
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Synthetic Long Put Position
A synthetic long put position is created by going long a call option and shorting the underlying
stock.
Continuing with Maybank example, Strategy to replicate long put position:
Short, Maybank stock @ RM 12.00

Long, RM 12.00, Maybank call @ .20
Long Put = Short Stock + Long Call
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Synthetic Long Put Position
Long Put = Short Stock + Long Call
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Synthetic Short Put Position
A synthetic short put position is created by going long the underlying stock and going short the call
option on the stock.
The short put position is a neutral to bullish strategy that aims to profit from either stagnant
underlying stock price or a marginal up movement.
Continuing with Maybank example, Strategy to replicate short put position:
Long, Maybank stock @ RM 12.00

Short, RM 12.00, Maybank call @ .20
Short Put = Long Stock + Short Call
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Synthetic Short Put Position
Short Put = Long Stock + Short Call
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Given the assumptions of the put-call parity, a long call and short put position have a cashflow profile
that is equivalent to that of a long position in the underlying stock.
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Put-Call Parity and Arbitrage
The put-call parity describes an equilibrium pricing relationship between calls and
puts written on the same underlying asset, of the same maturity and exercise price.
If a synthetic strategy produces a cash flow equivalent to that of the replicated asset,
it follows that there must be a pricing equilibrium between the two.
A simple version of the put-call parity:
S = C + P
This version ignores interest rates and the timing difference in cash outlays.
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By bringing in the interest rate, the put call parity equation is reformed as following:
S K(1 + r)t = C + P
Where
S = stock price (price of establishing long stock position)
r = annualized interest rate
K = exercise price of the options
t = days to maturity of option
C = call premium
P = put premium
An important implication is that any deviation from the above relationship constitutes relative
mispricing and would give rise to an arbitrage opportunity.
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Put-Call Parity and Arbitrage: Illustration
Suppose, Malaysian Oxygen Bhd. (MOX) has a current stock price of RM 11.00. RM 10.00 call and
put options on the stock with 90 days to maturity are quoted at RM 1.77 for the call and RM 1.00
for the put. The annualized risk-free interest rate is 10%.
Mispricing is checked via using the put call parity formula
S K(1 + r)t = C + P
RM 11.00 RM 10(1.10).25 = RM 1.77 RM 1.00
RM 11.00 RM 9.76 = RM 0.77
RM 1.24 > RM 0.77
The put-call parity is violated. There is a mispricing differential of RM 0.47 (RM 1.24 RM 0.77)
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The arbitrage strategy would be:
Short stock
Lend an amount equal to PV of exercise price
Long call
Short put
The strategy is riskless since the net cash flows at maturity is zero.
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The 47 sen profit can be explained as follows via calculations:
In replicating the long stock position at an exercise of RM 10, we are buying the stock at RM 10.
However that stock had been shorted (sold) for RM 11 earlier, giving a RM 1.00 profit on exercise.
Adjusting this for the difference in option premiums and interest earned on lending, we get:
Proceeds from short stock = RM 11.00

Purchase price of stock on exercise = (RM 10.00)
Premium paid for call option = (RM 1.77)
Premium received for put option = RM 1.00
Interest earned on lending = RM 0.24
Arbitrage profit = RM 0.47
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Mispricing and Arbitrage: Illustration
Suppose, Malaysian Oxygen Bhd. (MOX) has a current stock price of RM 11.00. RM 10.00 call and
put options on the stock with 90 days to maturity are quoted at RM 1.77 for the call and RM 0.33
for the put. The annualized risk-free interest rate is 10%.
Mispricing is calculated in following way.
S K(1 + r)t = C + P,
RM 11.00 RM 9.76 = RM 1.77 RM 0.33
RM 1.24 < RM 1.44
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The arbitrage strategy is as follows:
Long stock
Borrow an amount equal to PV of exercise price
Short call
Long put
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Determining Arbitrage Strategy
The deviations from parity imply relative mispricing.
Decision to which strategy should be used it could either be the earlier illustrations of going long the
cheaper side of the equation or alternatively by comparing each of the three traded assets (stock, call,
put) quoted price to the price implied by the put-call parity.
Illustration: In previous illustration MOXs stock price was RM 11.00, call premium = RM 1.77, put
premium = RM 1.00 while PV of exercise price was RM 9.76.
In determining the parity price of each of the assets, the rearranged the put-call parity equation as
follows:
S = C P + K(1 + r)t
C = S + P K(1 + r)t
P = C S + K(1 + r)t
K(1 + r)t = S + P C
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Determining Arbitrage Strategy
Illustration Contd.
By using the earlier equations, we calculated the parity values, summarized above.
The overvaluation and undervaluation indicates what strategy should be used, since arbitrage
always involves buying (long) the undervalued asset and selling (short) the overvalued asset, the
arbitrage strategy here would be short stock, long call and short put.
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Conversion and Delta Neutral Trading
The put-call parity describes a pricing equilibrium between the underlying stock and
the call and put option on the stock.
When the pricing equilibrium does not hold, there is deviation from parity.
The strategy used to arbitrage such mispricing is the conversion or reverse conversion
strategy.
The conversion and reverse conversion are delta-neutral trading strategies.
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A delta-neutral strategy is essentially a trading strategy which has an overall delta of
zero for the whole position.
Delta determines the rate of change in option value for a given change in the
underlying stock value.
The delta of a long stock position in one underlying stock equals +1.0, that of a short
stock position is 1.0.
Given the same underlying, maturity and exercise price:

Call delta Put delta = 1.0
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In the conversion strategy, we go long the underlying stock while the option positions
replicate a short stock position. Thus the net delta = 0.
In a reverse conversion, we short the underlying stock while the option positions
replicate a long stock position.
The net has a delta = 0 since the 1.0 delta of the short stock position is equally offset by +1.0
delta of the replicated long stock position.
As long as the underlying stock does not experience huge jumps, the delta-neutral
position is considered riskless.
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Put-Call Parity Empirical Evidence
Empirical work has found that in most cases the deviations from put-call parity are
the result of several institutional factors.
Example: bid-ask spreads and brokers commissions
Deviations from parity may also be the result of regulations.

Example: The short selling prohibition regulation in Malaysia.
Deviations may also be the result of non-synchronous trading.

Example: Day end close prices may show deviations whereas intraday data may not.
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REPLICATION, SYNTHETICS AND ARBITRAGE

You should also be able to understand the importance of why equilibrium

There are six basic strategies:

Two simplifying assumptions are made for these strategies:

Synthetic Long Stock Position

Strategy: (to replicate long stock position)

Strategy: (to replicate long stock position)

Long, RM 12.00, Maybank call @.20

Long Stock = Long Call + Short Put

Long Stock = Long Call + Short Put

Short, RM 12.00, Maybank call @ .20

Short Stock = Long Put + Short Call

Short Stock = Long Put + Short Call

Long, Maybank stock @ RM 12.00

Long Call = Long Stock + Long Put

Long Call = Long Stock + Long Put

Short, Maybank stock @ RM 12.00

Short Call = Short Stock + Short Put

Short Call = Short Stock + Short Put

Continuing with Maybank example, Strategy to replicate long put position:

Short, Maybank stock @ RM 12.00

Long Put = Short Stock + Long Call

Long Put = Short Stock + Long Call

Continuing with Maybank example, Strategy to replicate short put position:

Long, Maybank stock @ RM 12.00

Short Put = Long Stock + Short Call

Short Put = Long Stock + Short Call

A simple version of the put-call parity:

Mispricing is checked via using the put call parity formula

Proceeds from short stock = RM 11.00

Arbitrage profit = RM 0.47

Mispricing is calculated in following way.

RM 1.24 < RM 1.44

The conversion and reverse conversion are delta-neutral trading strategies.

Given the same underlying, maturity and exercise price:

Deviations from parity may also be the result of regulations.

Deviations may also be the result of non-synchronous trading.

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