Lorenzo Bretscher Derivatives Spring 2023

1. American call prices in $ on June 1st, 2001 for a chain on stock of TMK Inc. are reported in
the table below:
Strike ($) June July August September
110 8.88 12.50 15.00 18.00
120 1.50 3.75 3.00 4.25
130 1.00 2.25 2.88 5.00

The current stock price is 119.5$. Assume that the last trade for all of these option contracts
occurred at exactly the same time, and that TMK Inc. will not pay dividends until October
2001.

a) Identify three different pricing discrepancies in the table above and describe why the
prices violate no-arbitrage restrictions, and specify which restriction they violate.
b) Propose an arbitrage strategy to take advantage of each of the anomalies you identified
in point a).
c) You observe the September call and put European options on the same stock with 110$
strike are very liquid and traded contracts, and you conclude it is very unlikely that
they are traded at a price different from the no-arbitrage value. The aforementioned call
and put are quoted at 16$ and 5.15$ respectively. Compute the no-arbitrage price of a
September forward contract on the same stock.
d) Suppose the forward contract at point c) is quoted at 122$,and that you are not allowed to
borrow at all. Propose a trading strategy to take advantage of the arbitrage opportunity
in the market.

Solution

a) The following three anomalies are present in the table:

– the June call with strike K = 110$ is worth only 8.88$, but exercising it immediately
would yield 9.50$, that is it violates the following bound:

Ct ≥ St − K · e−r·(T −t) ≥ St − K

– the July call with strike K = 120$ is worth more than the August call with strike
K = 120$ (3.75$ vs 3.00$), violating the positive relationship between call premia
and time to maturity.
– the September call with strike K = 120$ is worth less than the September call with
strike K = 130$ (4.25$ vs 5.00$), violating the negative relationship between call
premia and strike price.
b) The following trading strategies allow to take advantage of the discrepancies above:

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Lorenzo Bretscher Derivatives Spring 2023

– buy the June call option and exercise it immediately.

– calendar spread: buy the August call with strike K = 120$, sell the July call with
strike K = 120$, and invest the difference at the riskfree rate. When the July call
expires, either exercise the August call, or sell it.
– vertical spread: buy the September call with strike K = 120$, sell the September
call with strike K = 130$, and invest the difference at the riskfree rate.
c) If no-arbitrage holds, the put-call parity implies:

ct + K · e−r·(T −t) = pt + St

from which the three-month interest rate r can be obtained. This yields:
1 K 1 110
r= ln = 3 ln = 4.94%
T − t p t + St − c t 12
5.15 + 119.5 − 16

The no-arbitrage forward price Ft is therefore:

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Ft = St · er·(T −t) = 119.5 · e0.0494· 12 = 120.98 $

d) Since Ft > St · er·(T −t) , if you were allowed to borrow at the riskfree rate, the following
strategy would guarantee an arbitrage profit of Ft − St · er·(T −t) = 1.02$.

Since the put and call options prices are free of arbitrage, one can replicate riskfree
borrowing using the put-call parity. Since

K · e−r·(T −t) = pt − ct + St
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one can borrow K · e−r·(T −t) = 110 · e−0.0494· 12 = 108.65$ by going long on one call and
shorting one put and one unit of the underlying. To implement the strategy above, one
needs to borrow St = 119.5$ > 108.65$. Therefore, the following strategy allows to take
advantage of the arbitrage opportunity in the presence of the borrowing constraint:

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Lorenzo Bretscher Derivatives Spring 2023