Al.The initial price of the stock is So 17 and the price follows the binomial mo

Question

Al.The initial price of the stock is So 17 and the price follows the binomial model in which in each period the price can go up by the factor u or down by the factor d. The numbers u, d, and the interest rate r are not known to us. A company Not Very Smart Bank Made Solely for The Purposes of This Problem hopes to make money by trading the European call options on this stock with strikes 14, 26, and 35 and expiration T-20. It has published the following prices for which it is willing to buy and sell the options: Strike Bid Ask 14 41 42 2631 32 3520 21 Prove that there is an arbitrage opportunity and explain how this arbitrage can be obtained.

Explanation / Answer

Answer :

A person buys call alternative pregnant price to increase. So here present are two habits in which arbitrage can be done:

1) Buy 35 hit call option at 21 and sell 14 strike name option at 41. So cash flow= +41-21=+20

2) Buy 26 hit call option at 32 and sell 14 strike call choice at 41. So cash flow= +41-32=+9

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