A mis-priced call in two period world:

Notes:
1. Two-period return will be geometric mean (average) of two ‘one-period return’.
2. If call is overpriced at t0 and also over priced at end of t1; the return will be less than the
risk-free return. The return earned over 2nd period will more than risk-free rate. The
overall return, i.e. periods 1 and 2, will be more than risk-free rate.
3. If call is overpriced at t0 and becomes correctly priced at end of t1; the return earned
over 1st period will be more than risk-free rate. The return earned over t2 will be equal to
the risk-free rate. Thus, the full two-period return will be more than risk-free rate.
4. If call is overpriced at t0 and becomes underpriced at end of t1; the return earned in 1st
period will be more than the risk-free rate. At this point, the 1st period hedge is closed out
and a new hedge is initiated for 2nd period to take long position in call and short position
in h stocks. The return in second period will more than risk-free return. And overall two
period return will be much higher than risk-free rate.
If R1 is return earned in period 1 and R2 is return earned in period 2 on hedge portfolio
(consisting of h stocks and a call) and r is risk-free rate, the return will be:
T0 T1 T2 Over all return
Call Over-priced Over-priced Correctly Priced
Return -initiation R1> r R2>r R1,2 >r
Call Over-priced Correctly priced Correctly priced
Return --initiation R1>r R2=r R1,2 >r
Call Over-priced Under-priced Correctly priced
Return --initiation R1>r; close out the portfolio R2>r R1,2much higher
at end t1 and initiate another >r
portfolio by buying
underpriced call and short h
stocks