Suppose you are given the following prices Current stock pri

Suppose you are given the following prices: Current stock price is $42. One month maturity Call(X=40)=$4.5, Two month maturity Call(X=40)=$3. All options are American type. Is there a profit opportunity based on these prices? If so, what would you do? If not, why not?

Solution

The near month call option (1 month maturity) is quoting at a higher price than the far month (2 month) call option at the same strike price, this should not happen if the cost of carry of positive. Hence there is a possible arbitrage opportunity as below: