A pair of European call and put options have identical strike price of $40 and identical maturity of eight months. The underlying stock is currently trading at $40 per share. The risk-free rate is 3% per annum, compounded semi-annually. The company has announced an annual dividend of $1.80 per share, to be paid in four quarterly instalments, with the first one to be paid three months from now. If the call and put options are selling for $5 and $5.50, respectively, are there any arbitrage opportunities? If your answer is yes, show how a trader can take advantage of the opportunities. Describe in detail the initial positions, the unwinding of these positions at option maturity and how the arbitrage profit is determined. If your answer is no, explain why not.

Answer rating: 100% (QA)

To determine whether there is an arbitrage opportunity we need to calculate the theoretical prices of the call and put options using the BlackScholes ... View the full answer