Explanation:
We use put-call parity to calculate the theoretical value of the options:
P = \`$0.60`As the put actually sells for $1.20, there is an arbitrage:
Sell high (i.e., sell the put in the market for 1.20)
Buy low (i.e., buy a call, sell the stock, and invest the PV of the strike)
The profit earned is 1.20 - 0.60 = \`0.60`$.
(Book 3, Module 39.2, LO 39.c)
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Question 6
The price of a non-dividend-paying stock is $18. A six-month European call option with a strike of 16 sells for $3. A European put option on the same stock with the same strike and maturity sells for $1.20. The discretely compounded risk-free rate is 5%. Which of the following is correct regarding an arbitrage opportunity?
A
No arbitrage opportunity exists.
B
Sell the put, buy the call, sell the stock, and invest the PV of the strike in a bond.
C
Buy the put, sell the call, buy the stock, and borrow the PV of the strike in a bond.
D
Buy the put, sell the call, buy the stock, and invest the PV of the strike in a bond.
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