Question 3

Consider five-month European call and put options on British pounds with an exercise price of $1.1700. The current price of the put option is $0.0416. The current spot price of British pounds is $1.1706. The riskless interest rate is 4% in the U.S. and 5% in the U.K. (both of these rates are annualized and continu- ously compounded).

(a) Given the price of the put option, what should be the current price of the call option? (Please report your answer to four decimal places.)

(b) Suppose the current price of the call option is $0.0399. Demonstrate how you could earn costless arbitrage profits. Please be sure to clearly show the transactions you would undertake and the amount and timing of your profits.