Question

You happen to be checking the newspaper and notice an arbitrage opportunity. The current stock price of Intrawest is $20 per share and the one-year risk-free interest rate is 8%. A one- year put on Intrawest with a strike price of $18 sells for $3.33, while the identical call sells for $7. Explain what you must do to exploit this arbitrage opportunity.

Answer 1

Answer:

Using put call parity:

C + X/(1+r)^n = S+P

C + 18/(1+0.08)^1 = 20+3.33

C + 18/1.08 = 20 + 3.33

C +  18/1.08 = 23.33

C + 16.67 = 23.33

C = 23.33 - 16.6667

C = 6.67

The call price ($7)  is over price, so we should sell call and buy underlying ($6.67). After one year, the underlying option will get a gain of $0.33 ($7-$6.67). So, we should exploit this arbitrage opportunity.