European Options and Fixed Cost Spreads

Abstract

This paper revisits the put-call parity condition for European options, on both non-dividend paying and dividend paying stocks, in the presence of fixed costs spreads. It demonstrates that the put-call parity condition becomes a set of inequalities under these conditions. A model patterned on the Roll model for fixed cost bid-ask spreads is postulated, and its estimation using a genera lized method of moments (GMM) approach, is suggested. Finally, the paper demonstrates that in the presence of bid-ask spreads, European options on non-dividend-paying stocks may have a negative time value, unlike the case of such options in the absence of spreads. Also, due to the presence of such spreads, there could be situations, where both calls and puts with the same exercise price are simultaneously exercised.