Question

A one-month European put option on a non-dividendpaying stock is currently selling for $2.50. The stock price is $47, the strike price is $50, and the risk-free interest rate is 6% per annum. What opportunities are there for an arbitrageur?When will the put be exercised?

Answer 1

Answer:

In

this case the present value of the strike price is 50e =49.75e

Because

25<49.7547.00

The condition in equation (10.5) is violated. An arbitrageur should borrow $49.50 at 6% for one month, buy the stock, and buy the put option. This generates a profit in all circumstances.If the stock price is above $50 in one month, the option expires worthless, but the stock can be sold for at least $50. A sum of $50 received in one month has a present value of $49.75 today. The strategy therefore generates profit with a present value of at least $0.25. If the stock price is below $50 in one month the put option is exercised and the stock owned is sold for exactly $50 (or $49.75 in present value terms). The trading strategy therefore generates a profit of exactly $0.25 in present value terms

Explanation: