Suppose you observe a non-dividend-paying stock trading for $40. The call options on this stock have 0.5 year to mature, the continuously compounded risk-free interest rate is 8% p.a., and the exercise price is $40. Based on an analysis of this equity, the estimate for the annual stock return volatility is 30%.

(b) Use the same data as in part (a) and only suppose that the call price is $5. You determine that an arbitrage opportunity is available and assume that you form a replicating portfolio to take advantage of this opportunity. What is the replicating portfolio and what are the net cash flows from implementing the arbitrage strategy at time 0?

( Data in a : compute the two-period binomial price of the European call on this stock, and the anwer is $ 4.89 )