Question
I would like help with the following finance question and understanding the jargon. A trader observes that a) A put on stock X which does
I would like help with the following finance question and understanding the jargon.
A trader observes that a) A put on stock X which does not pay dividends with strike price $20 and exercisable in one year trades at $3 and b) A call on the same stock with the same strike price and also exercisable in one year trades at $25. If the stock trades today at $30/share and the risk-free rate is 10%, design a profitable arbitrage strategy for the trader.
I used the put-call parity formula and determined it to be:
$22 = $11.82 or $22>$11.82
Not sure if I did the math correctly, but arrived at $22 by taking the difference between the call price and put price. I then arrived at $11.82 by $30 - (20/1.10).
The way I understand it, the trader should buy the cheap side which in this case is the put and sell the expensive one. However, I can't wrap my head around what exactly that means or what strategy they should follow. And, I'm also not sure if my calculations are correct. Can you please help?
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