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Details of prices of stock, derivatives and interest rates are as follows: - ABC’s stock price is $22.50 at time 0 - The European options on ABC have a common strike price K=$20 and mature in T=6 months. Today’s put price is $0.50. - The continuously compounded risk-free interest rate is 5% per annum. - Non dividends are paid on ABC’s stock over the option’s life.
Required:
(a) Determine the price of the call on ABC’s stock by creating the following two portfolios:
? A stock purchase plan portfolio: long stock and short bonds to borrow the present value of strike
? Synthetics short stock: short call and long put
(b) Suppose you find that an errant trader quotes a call price of $4. Using the portfolio created in part (a), what is your immediate arbitrage profit.
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