My question is for a synthetic call option why do we need to borrow the present value of the strike price and what does it mean in a simple language explanation. Similarly why do we need to lend the present value of the stock at risk-free rate and what does it mean in simple language explanation? Please also clarify the significance of risk free rate? Why is it used in put call parity. Synthetic Call Option: If an investor believes that a call option is over-priced, then he/she can sell the call on the market and replicate a synthetic call.Borrow the present value of the strike price at the risk free rate and purchase the underlying stock and a put.Synthetic Put Option: Similar to the synthetic call option. A synthetic put can be created by re-arranging the put-call parity relationship, if the trader believes the put is overvalued.Synthetic Stock: A synthetic stock can also be created by rearranging the put-call parity identity. In this case, the investor will buy the call, sell the put, and lend the present value of the strike at the current risk free rate.

Synthetic calls and synthetic puts are the two types of synthetic options available. Both forms of…

Answered: My question is for a synthetic call…

International Financial Management

14th Edition

ISBN:9780357130698

Author:Madura

Publisher:Madura

Chapter7: International Arbitrage And Interest Rate Parity

Section: Chapter Questions

Problem 4BIC

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My question is for a synthetic call option why do we need to borrow the present value of the strike price and what does it mean in a simple language explanation. Similarly why do we need to lend the present value of the stock at risk-free rate and what does it mean in simple language explanation?

Please also clarify the significance of risk free rate? Why is it used in put call parity.

Synthetic Call Option: If an investor believes that a call option is over-priced, then he/she can sell the call on the market and replicate a synthetic call.
Borrow the present value of the strike price at the risk free rate and purchase the underlying stock and a put.

Synthetic Put Option: Similar to the synthetic call option. A synthetic put can be created by re-arranging the put-call parity relationship, if the trader believes the put is overvalued.
Synthetic Stock: A synthetic stock can also be created by rearranging the put-call parity identity. In this case, the investor will buy the call, sell the put, and lend the present value of the strike at the current risk free rate.

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