Question

Sample Question:

Please show working so I can follow the steps:

A 1 year call option with a strike price of $7 is selling for $1.75. The stock price is currently $6.

a. What is the price of the corresponding put having the same expiry and exercise price? The present value of the exercise price is $4.

b. The put is currently selling at $0.30. Is the put over- or under-priced?

c. What steps would you take to make an arbitrage profit? (Don't need calculations for part C - just explain please!)

Answer 1

a) As per call put parity

Price of call option + Present value of strike price = Price of put option + Spot price

Thus 1.75 + 4 = Price of put option + 6

5.75 = Price of put option + 6

Thus Price of put option = -0.25

Price of put option can't be negative hence price of put option = 0

b) If put option is trading at $ 0.3 , than it is over valued as theoritically value of put option should be 0

c) To Arbitrage , one can sell put option and can buy equivalent of underlying shares. This will create zero risk based strategy and will generate profit