Question

7. A stock price (which pays no dividends) is $50 and the strike price of a two year European put option is $54. The risk-free rate is 3% (continuously compounded). Compute the lower bound for the put option such that there are arbitrage opportunities if the price is below the lower bound and no arbitrage opportunities if it is above the lower bound

Answer 1

LOWER BOUND FOR THE OPTION

= $54 e-0.03045 *2 - $50

= ($54 * 0.94092) - $50

= $50.81 - $50

= $0.81

Note

3% is the simple interest but 0.03045 is the compound interest.