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In actuality, American options are traded on an option-adjusted-spread (OAS) basis, where OAS=Model Price-Market Price For example, the value of the call bond is calculated

In actuality, American options are traded on an option-adjusted-spread (OAS) basis, where

OAS=Model Price-Market Price

For example, the value of the call bond is calculated according to our interest rate model is $100.3564, while the call bond is actually traded at $100.1 in the market. This produces OAS=0.2564>0. It seems as if the call bond has been undervalued and an arbitrage is warranted.

In this case, arbitrage means trading between the call bond and another portfolio, which replicates

the call bond.

a. How would you construct a replicating portfolio?

b. Compute the value of your replicating portfolio.

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