Question

If the call option were selling at $4, what would you do to create a riskless arbitrage strategy? Explain how the strategy is maintained over the two binomial periods assuming the underlying asset price declines in the first period. Construct a table to demonstrate the exact strategy and the cashflows from the strategy. S0 = 10, T = 2 months, u = 1.5, d = 0.5, r = 0.05, K = 7, D=0.

Answer 1

Given So=10 and T= 2 months , let us construct a binomial tree. This binomial tree is given in the snapshot attached below. Now as per the binomial tree our implied call value is coming out to be 4.125. This value is after two months. So its present value is 4.125/e^0.05*2/12=4.16.

Now since the same call option is trading at 4 so we can buy the call option for risk free profit of 0.125