Use the same data as in the previous problem only suppose that the call price is $5 instead of $4.110.
In previous problem
Let S = $40, K = $40, r = 8% (continuously compounded), σ = 30%, δ = 0, T = 0.5 year, and n = 2.
a. At time 0, assume you write the option and form the replicating portfolio to offset the written option. What is the replicating portfolio and what are the net cash flows from selling the overpriced call and buying the synthetic equivalent?
b. What are the cash flows in the next binomial period (3 months later) if the call at that time is fairly priced and you liquidate the position? What would you do if the option continues to be overpriced the next period?
c. What would you do if the option is underpriced the next period?