Question
Suppose that you observe the following data: XYZ Widgets stock is trading at $100 per share. European Call Option with T = 1 and K
Suppose that you observe the following data: XYZ Widgets stock is trading at $100 per share. European Call Option with T = 1 and K = $110 is trading for $20. The risk-free rate is 5%, annually compounded. 1. If the Law of One Price holds, what should the price of a European Put Option with T = 1 and K = $110 be? 2. Suppose instead that the price of the European Put Option is $23. Construct a trading strategy that takes advantage of this violation of the Law of One Price. Hint: Start by constructing a synthetic share of stock using a call, a put, and the risk-free asset.
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