Question

A call option with exercise price of $120 is priced at $3, the underlying security price is $125. At the same time, a put option for the same underlying security with the same exercise price and maturity, is price at $3. Assume both options are of American style. Which of the following most likely to be correct?A.Both options are overpriced. B. The call option is underpriced. C. The put option is overpriced.D. Both options are underpriced. E. None of the above.

Answer 1

Holder of American option has the right to exercise option prior to maturity.

Price of underlying security (S) = $125

Exercise price (X) for both call and put = $120

Maturity for both call and put is also same

Call option price (premium) = $3

For call option:

In the money option : S - X > 0

Out of money option : S - X < 0

For put option:

In the money option : X -S > 0

Out of money option : X -S < 0

In above question :

Price of call option = $3, but it should be 125 - 120 =$5

Hence, call option is underpriced.

Price of put option = $3, but it should be 120 - 125 = 0 because price cannot be negative.

Hence, put option is overpriced.

And therefore the answer is E. None of the above because call option is underpriced and put option is overpriced.