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QUESTION 2 The price of an American call option on a non-dividend paying stock is $8.00. The stock price is $29.00, the strike price is

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QUESTION 2 The price of an American call option on a non-dividend paying stock is $8.00. The stock price is $29.00, the strike price is $28.50 and the expiration date of the American call is 7 months. The risk-free rate of interest is 20% p.a. continuous compounding for all maturities. Required (a) Derive upper and lower bounds for the price of an American put option on the same stock with the same strike price and expiration date. (3 marks) (b) If the American put price is trading at $7.70 clearly explain how to exploit any arbitrage opportunity (if any) and the quantum (to the extent this can be specified) from undertaking an arbitrage strategy. Assume you can short sell shares if required and borrow or lend at the risk-free rate. There are no brokerage fees or other transaction costs associated with buying or selling an option or a share. (4 marks)

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