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3. [Put-Call Parity Condition] At date 1, there is a European call option on the dollar with a strike price of K = 0.75 and

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3. [Put-Call Parity Condition] At date 1, there is a European call option on the dollar with a strike price of K = 0.75 and an expiration date of T > t and a European put option on the dollar with the same strike price and expiration date. Both are notional one dollar (N = 1). The risk-free interest rate in the UK is r' = 1/5 (20%) and the risk-free interest rate in the US is r'a = 1/4 (25%). The current spot exchange rate is S, = 0.8 (that is, each dollar costs 80 pence). (a) You buy the put option at the price of P, = 2.5 pence. Explain the position you have at the expiration date T. (b) Five minutes later you find out that the equivalent call is trading at C = 5 pence. You know the put-call parity condition for European options is C-P,= S, (1+r) K (1+r) Identify an arbitrage opportunity. What position do you take? Explain all the cash flows at date t and at the expiration date T

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