A tool employing the principle of put-call parity determines the theoretically correct relationship between the prices of European put and call options with the same underlying asset, strike price, and expiration date. This relationship involves the current price of the underlying asset, the strike price, the risk-free interest rate, and the time to expiration. For instance, if the market price of a call option is higher than what put-call parity dictates, a trader could theoretically profit by selling the overpriced call and simultaneously buying the corresponding put and underlying asset.
This principle provides a critical framework for options pricing and arbitrage identification. Deviations from parity suggest market inefficiencies, presenting potential trading opportunities. Its historical development stems from the foundational work in financial economics on arbitrage pricing theory. Understanding and utilizing this principle allows for a more sophisticated approach to options trading and risk management.