Put Pricing Through Put-Call Parity and Short-Sale Funding
Summary
The document rearranges European put-call parity to explain the components of put value when there are no dividends. It frames the put's intrinsic value as the strike minus the stock price, with time value reflecting both the call's upside protection and the funding adjustment embedded in the discounted strike. The central intuition is that short selling generates cash at the outset, while buying a put does not provide that cash directly; parity accounts for the difference through a borrowing rebate.
The discussion is conceptual and gives no pricing data or empirical test. It notes that actual stock borrowing costs could reduce the rebate available in practice, but leaves that question unresolved. The explanation is limited to the stated European-option, no-dividend parity setup and does not address other market frictions or option styles.
Key ideas
- Put-call parity can be rearranged to separate intrinsic value from time value in put pricing.
- The discounted strike creates a funding adjustment that can be understood as a rebate associated with short-sale proceeds.
- A put provides downside protection, while the call term in the rearranged equation represents upside protection.
- Stock-borrow costs may affect the practical size of the funding rebate, but the document does not quantify this effect.
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Full text
# Intuitive explanation of put option pricing based on put-call parity
# Intuitive explanation of put option pricing based on put-call parity
Assuming no dividends, the put-call parity equation says:
$c + Ke^{-rT} = p + S$
where $c$ is the price of the European call, $p$ is the price of the European put, $S$ is the current stock price, $K$ is the option strike price, $r$ is the risk-free rate, $T$ is the time to expiry.
In You Can Be a Stock Market Genius by Joel Greenblatt, a basic explanation of call option pricing appears in chapter 6:
> The bottom line is that buying calls is like borrowing money to buy stock, but with protection. The price of the call includes your borrowing costs and and the cost of your “protection” — so you’re not getting anything for free [...]
Intuitively, there is a borrowing cost because the owner of the call does not have to tie up $\\\$K$ (which is effectively "borrowed") until the exercise of the call option.
I instantly recognized this as an excellent intuitive interpretation of a rearrangement of the put-call parity equation:
$c = \overbrace{S - K}^\text{intrinsic value} + \overbrace{\underbrace{K - Ke^{-rT}}_\text{borrowing cost} + \underbrace{p}_\text{downside protection cost}}^\text{time value}$
The book doesn't explain put options, so I tried to rearrange the equation to similarly explain the price of put options:
$p = \overbrace{K - S}^\text{intrinsic value} + \overbrace{\underbrace{Ke^{-rT} - K}_\text{?} + \underbrace{c}_\text{upside protection cost}}^\text{time value}$
However, I am unable to find an intuitive interpretation of this equation. Can someone help me out?
I tried: "buying puts is like short-selling a stock, but with protection ...", but I don't know how to intuitively explain $Ke^{-rT} - K$, which looks like a "borrowing rebate".
## Answer by StackG (score 3)
https://quant.stackexchange.com/a/57312
If you sold a stock short, you receive cash at $t=0$, so there is a negative borrowing cost. If you buy a put, you don't receive this funding.
So while a call would be too cheap if it didn't include a funding cost incurred when buying the stock, similarly a put would be too expensive if it didn't include the "borrowing rebate" that you mention, for the funding received from the short selling cash.
Since in reality it costs something to borrow a stock (in order to short), I wonder if in the real world, this 'borrowing rebate' might be slightly reduced do to the stock-borrow-cost... but that's another question.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.