I came across this phrase/term while reading about Put-Call parity of European Options.
What I could understand was that it's represented by two notations:
I can understand these notations but can't comprehend the phrase "Present Value of Strike Price".Can someone explain in layman's language what present value of strike price means?
Source: http://www.putcallparity.net/
Dear Anand,
If you can kindly share the source of your reading, maybe I can explain this better with the context of what you have read.
Otherwise, the present value in Put Call Parity represents the strike price discounted at the rate of a bond (not interest bearing) and brought back to time “t”, where “t” represents the time to expiry.
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Strike price is also the exercise price (the price at which shares are settled by the contract holder and seller, ideally some real money which has be settled buy buying shares at Strike Price or Delivering shares at Strike Price, if you dont have shares to deliver, you need to buy from market and deliver) Strike Price, K
A strike price is exercised only after some time, on the expiry day, the time period between today and the date of expiry is the Time to Maturity, T
For any money you hold now (say you have put in an FD) you can earn a certain rate of interest. Assume this is the Risk free rate of return, r
You hold 100 rupees today, and it is equivalent to 105 rupees after 6 month, because in this 100 rupees you can earn some rate of return.
Conversely, the money you will hold after 6 months rupees 105, is only worth 100 rupees today.
Similarly the Strike Price or Exercise Price at maturity (on expiry) is only worth some lesser value as of today.
This is what they say, Present Value of the Strike Price and it is given by the equation
(Present Value of K) = K x e ^(-r xT)
Source:http://www.putcallparity.net/
Else can you suggest me a book with good explanations on options? NSE workbook doesn’t have enough explanations for terms.
Anand, to appreciate the concept of Put Call parity, it is essential to know how the present value of a money works.
In summary, all PCP states is that the price of a call option + the present value of the strike price should be equal to the price of the put option + the price of the spot price.
If the two are not equal, then you have an arbitrage opportunity.