If the market price of a European put option is lower than the price suggested by the one-period binomial model, what is the appropriate arbitrage strategy?

A. Sell the put option and short the underlying.
B. Buy the put option and short the underlying.
C. Buy the put option and long the underlying.

Correct Answer: C

As the put option is under-priced, we should buy it. To create a hedge portfolio we should also buy the underlying as well. The portfolio will give us a risk-free rate of return higher than the risk-free rate.

Note that the arbitrage strategy is to long or short positions in BOTH instruments.