Question

You happen to be checking the newspaper and notice an arbitrage opportunity. The current stock price of Intrawest is $20 per share and the one-year risk-free interest rate is 8%. A one-year put on Intrawest with a strike price of $18 sells for $3.33, while the identical call sells for $7. Explain what you must do to exploit this arbitrage opportunity. Berk, Jonathan; DeMarzo, Peter; Harford, Jarrad. Fundamentals of Corporate Finance (2-downloads) (Berk, DeMarzo

Answer 1

Using the Put-Call parity principle where the following relationship holds:

Covered Call = Protective Put

Using the above, find the call price:

Call + Strike price / (1 + risk free rate) = Stock price + Put

Call + 18 / (1.08) = 20 + 3.33

Call + 16.67 = 20 + 3.33

Call = 23.33 - 16.67

Call = $6.66

The call option is overvalued at $7 so sell the Call option and buy the Put option and the Stock and borrow $16.67 which is the present value of the Put.

The net gain will be:

= 7 - 6.66

= $0.34