European-style options on foreign currencies trade at the Philadelphia Exchange. A call option on sterling with an exercise price of 0.925 £/$ and a time to expiration of 3 months has a price of 0.0125 £/$. The current price of sterling is USD 0.94 £/$, the volatility is 3%, the risk-free rate of interest on U.S. dollars is 5.40% continuous and the risk-free rate of interest on sterling is 5.80% continuous. Is there an arbitrage opportunity? If there is such an opportunity, what is the arbitrage profit and what is the strategy to earn it?

Answer rating: 100% (QA)

Yes there is an arbitrage opportunity in this situation The implied volatility of the call option is ... View the full answer