Put‐Call Parity and Market Efficiency

Abstract

OPTIONS HAVE CONSTITUTED THE most dynamic segment of the securities markets since the inception of the Chicago Board Options Exchange in April 1973, which was followed shortly thereafter by four other registered option exchanges. Until June 1977, only call options were traded on these registered option exchanges. At that time, each of the exchanges was permitted to commence trading in put options on five underlying securities. The initial success of the put options promises to provide the next major thrust to the registered options markets when they can be traded on all of the underlying securities listed on the exchanges. The advent of put trading on the registered exchanges is important because a deterministic relationship should exist between put and call prices, irrespective of investor demands, if both options are written on the same underlying security and have the same exercise (striking) price and expiration date.' This relationship exists because the put, call, and the underlying stock form an interrelated securities complex, in which any two of the three instruments can be combined in such a manner to yield the profit and loss opportunities of the third instrument. Because of conversion possibilities, theoretical put-call parity models can be developed to determine a put (call) price given a corresponding call (put) price and other relevant information. If the actual put or call price should deviate substantially from the parity price, an opportunity exists for investors to set up a riskless arbitrage position and earn more than the risk-free rate of return. The original put-call parity model was developed by Stoll [10] and later extended and modified by Merton [5]. These models were used by Stoll [10] and and Gould and Galai [3] to empirically investigate parity among over-the-counter (OTC) put and call options. While these studies basically supported the put-call parity theory, some inefficiencies in the relationship were also found to exist. Today's options market is vastly different from the OTC market, however. Major changes made by the registered options exchanges, including the standardization of contractual terms such as the exercise price and expiration date, and the creation of a central clearing corporation, have transformed the options market place from a thin, negotiated market to a competitive, auction market.2 Another