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Understanding Arbitrage: An Intuitive Approach to Financial Analysis by Randall Billingsley

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Chapter 5. Put-Call Parity and Arbitrage

It’s a wrong perception to believe that you can eliminate risk just because you can measure it.

Professor Robert C. Merton, Nobel Laureate in Economic Sciences, 19971

Put-call parity describes the relationship among the values of put and call options on the same stock and a riskless security such as a Treasury bill (T-bill).2 Specifically, the call price, put price, stock price, time to expiration, exercise price, and risk-free rate are related to one another systematically. Focusing on European options, we first demonstrate how the put-call parity relation holds. Then we show how to exploit deviations from the predicted relationship using arbitrage strategies. Next we explain how the relation can be ...

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