Homework Answers
After 1 year stock price at risk free rate = 60*1.1 = 66
Payoff after 1 year = $66-$50 = $16
Present value of the payoff = 16/1.1 = $14.55
This payoff is higher than the price of the call option. Hence, the call price is cheap and hence arbitrage is possible.
1)Sell the stock and encash $60
2)Buy the call option for $12
3)Invest the rest (60-12) = $48 at 10% for 1 year ($4.8 interest at the end of 1 year)
After 1 year, stock price S(T)
If the stock price is greater than 60
Profit = S(T)-50+60-S(T)+4.8 = $14.8
If the stock price is lesser than 60, but greater than 50
Profit = S(T)-50+60-S(T)+4.8 = $14.8
If the stock price is lesser than 50
Profit = 60-S(T)+4.8
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