Question
Consider a European-style call option with an exercise price of 105 euros expiring exactly in a year and a European-style put option with an exercise
Consider a European-style call option with an exercise price of 105 euros expiring exactly in a year and a European-style put option with an exercise price of 105 euros expiring exactly in a year. The current stock price is 110 euros, the risk-free interest rate is 10% per annum, the price of this call option is 14.50 euros and the price of put option is 2.50 euros. Suppose that you can borrow and lend the money at risk-free rate. For simplicity, suppose also that the transaction costs are zero. Assume also that there are no counter-party risks. Identify the mispricing and demonstrate (step-by-step) how to apply a risk-free arbitrage strategy that allows you to earn positive net profits? Identify clearly what instruments you will buy and what instruments you will sell short, etc. Calculate also the net profit from arbitrage. (Recall that the value of e is approximately 2.7183).
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