Question #72
Reading: Reading 31 Valuation of Contingent Claims
PDF File: Reading 31 Valuation of Contingent Claims.pdf
Page: 33
Status: Unattempted
Correct Answer: A
Part of Context Group: Q72-74
First in Group
Shared Context
Question
Susan discovers that the fair value for the $55 strike put is in fact $3.85. Which of the following is the most appropriate set of transactions to exploit the mispricing (ignore transaction costs)?
Answer Choices:
A. Write a call option, buy a put option, buy one share, borrow the PV of strike
B. Buy a call option, write a put option, buy one share, borrow the PV of strike
Explanation
The $55-strike put is currently underpriced compared to its synthetic ($3.33 < $3.85).
We therefore will want to go long the underpriced put and short the overpriced synthetic
to make an arbitrage profit.
Susan will be obliged to sell the shares at $55, so she also needs to buy the stock (so that
she has it to deliver) and borrow the PV of the $55 strike ($55 / (1.06)91/365 = $54.21). The
net result will be a receipt of $2.64 – $3.33 – $53 + 54.21 = $0.52 per share. Thus:
Write a call option, buy a put option, buy one share, and borrow the PV of strike.