Lar, Youâre correct I wrongly assumed we were discussing Equity markets. I am sure there are markets where the skew is opposite. Neo, Even Euro style deep in the money puts donât really trade below true intrinsic value. They do trade below what the generic idea of intrinsic is. Something like an SPX put which is cash settled Euro style appears to be below parity but its not below intrinsic since the proper hedge is the long term future. You buy the put and you technically should be buying the long term future which decays over the life of the put. If you can figure out a way to hedge the delta of the deep SPX put with a vehicle that does not decay, I suggest you do it in huge size.
Xflat, Youâre right, I do have that one backwards. This is what happens when itâs way past oneâs bedtime (is that OK as an excuse?). Thanks for the correction. âConversely, if implied drops, your time value will decrease at a greater rate than normal time decayâ. Definitely lack of clarity here. Need to determine what Iâm trying to say. My point of reference was European-style index options. Occasionally, calls will trade below intrinsic value. However, being so deep in-the-money I canât see any advantage â or point - in using these, nor do I see an arbitrage. For example: 5000 strike call premium: 2,895 underlying: 7945 days: 175 rate: 4% intrinsic value (discount): 5000+2895-7945=-50 These values were from DAX options, 21 Sep 07 (Last Trade), 20 lots. There were other examples. Arbitrage: long 5000 call at 2,895 short future at 7945. Regardless of outcome, at expiry the net gain will be 50 points. If the opportunity cost of carry (for the call) at â56 is included: 2895 â (2895 x e^(0.08 x 175/365)) = -56. 50 â 56 = -6, or no arbitrage. Presumably, the futureâs margin cost should also be accounted for. Is that correct? Should there a greater than 1:1 ratio? Grant.
Grant as I mentioned in my previous post. Euro sytle options appear to trade below intrinsic only because the difference in what you precieve to be intrinsic and where those trade is made up in the cost to cary the hedge.
European style equity calls can trade below intrinsic where a dividend is due prior to expiry. For example, Spot 500 Dividend due 25 Dividend paid 1 week Options expiry 2 weeks 480 strike call could priced at 5 American style options however, will never trade below intrinsic.