Suppose a call option with a strike price of 40 has a premiu

Suppose a call option with a strike price of $40 has a premium of $10, while another call on the same underlying stock has a strike price of $45 and a premium of $13. Both options expire at the same time. In this situation, an arbitrageur would...

a. buy the 45-strike call and sell the 40-strike call

b. buy both call options

c. sell both call options

d. do nothing because arbitrage is not possible

e. buy the 40-strike call and sell the 45-strike call

Suppose a call option with a strike price of $50 has a premium of $15, while another call on the same underlying stock has a strike price of $55 and a premium of $8. Both options expire at the same time. In this situation, an arbitrageur would...

a. do nothing because arbitrage is not possible.

b. sell both call options.

c.buy both call options.

d. buy the 55-strike call and sell the 50-strike call.

e. buy the 50-strike call and sell the 55-strike call.

Solution

1) Option (e)

buy the 40-strike call and sell the 45-strike call

Because the strike price is $40 with low premium, so buy that call and sell the other call to earn profit.

2) Option (d)

buy the 55-strike call and sell the 50-strike call

Higher strike price have low premium whereas the lower strike price have higher premium. So buying the $55 strike at lower premium will benefit the arbitrager.