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mattst
02-02-2007, 10:13 AM
I'm not sure how much of the question it is acceptible to give away like this, but here is my attempt to understand the solution without giving up too much of the question.

In this problem, there are two puts such that arbitrage is possible. To create a position to take advantage of the arbitrage you must sell a 1 year put and buy a 2 year put, which makes you .1.

After a year, the put that you sold is excercised as the strike price is 49.85, but the price of the stock is 48. So know you are forced to buy the stock for 49.85.

After two years, the put that you bought is worthless since the strike price is 54 but the price of the stock is 55. So you sell the stock for 55. Therefore:

profit = 55 - 49.85 e ^.08 + .1 e ^.16 = 1.12

The answer in the solutions is profit = 55 - 48 e^.08 + .1 e^.16 = 3.12

Why is the stock bought for 48 instead of 49.95 if you were the one to sell the put?

Abraham Weishaus
02-02-2007, 10:18 AM
If you look at the errata, I think it's phrased more clearly. The point is you may do one of 2 things:

(1) You're forced to buy the stock for 49.85, or

(2) Instead, there is a cash settlement in which you pay the put buyer 1.85 and then buy the stock on the open market for 48.00 (the market price).

Either way, you spend 49.85.