Suppose the put is trading at a price higher than your estimate of the cost of a replicating portfolio. Suppose you are confident in your volatility estimate of 30% per annum. What trades should you make today as the first step in locking-in an arbitrage profit? Be specific as to the sign and size of the positions you should take today in each security.

(b) Suppose that over the next three months Winetowat's share price first rises and then falls and finishes at $42.76 at the end of the three months. What will have been the nature of the trades you will have made over the months as a result of your strategy of locking-in the arbitrage profit you identified in part ?

(c) Now consider a correctly priced put option with three months to maturity and an exercise price of $48, i.e., consider a put trading at the value you determined in part If the stock price now increases from $50 to $51 over a very short interval (so short that the time to maturity is effectively unchanged), make a simple estimate of the change in the value of the put?

(d) What is the annual standard deviation of returns on the put given the current stock price and time to maturity?

(e) Suppose that Winetowat's beta is 0.66 and that the expected rate of return on Winetowat's stock price is 12% per annum. What is the beta of the put given the current stock price and time to maturity? What is the expected rate of return on the put per annum given the current stock price and time to maturity?

(f) Your answer to part ( should be an expected return below the risk-free rate of 4% per annum. Explain why the put has an expected return below the risk-free rate when you have in part that the put is clearly not riskless.

Answer rating: 100% (QA)

ANSWER a If the put is trading at a price higher than our estimate of the cost of a replicating portfolio we can lock in an arbitrage profit by creati... View the full answer