(a) You are doing analysis on DXG Ltd which is one of the market leaders in household product manufacturing industry. The common stock of DXG currently trades at $35 per share. The stock pays no dividends. To your surprise, a three-month DXG European put option with an exercise price of $40 sells for $3.0. The market interest rate is 5% per annum. Assume that there are no transaction costs.

(i) Explain why there is an arbitrage opportunity. (3 marks)

(ii) Explain the process of the arbitrage transactions now and in three months. (7 marks)

(b) LDG is a smart phone manufacturer. The common stock of LDG is currently trading at $40. The stock pays no dividends and it has annualized return volatility, , of 30%. Tony is attempting to value a 6-month LDG American put option with a strike price of $41 using the two-step binomial tree. The risk-free interest rate is 5% per annum.

(i) Draw and determine the stock price of the two-step binomial tree at each node. (3 marks) (ii) Compute the prices of the American put option at each node and label them onto the final tree diagram of (i) above.