- CFA Exams
- CFA Level I Exam
- Study Session 16. Derivatives
- Reading 49. Basics of Derivative Pricing and Valuation
- Subject 11. Binomial Valuation of Options

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**CFA Practice Question**

If the market price of a European put option is higher 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. Sell the put option and long the underlying.

C. Buy the put option and long the underlying.

**Explanation:**This strategy would replicate a loan that would charge us less than the risk-free rate.

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**User Contributed Comments**
6

User |
Comment |
---|---|

americade |
irrespective of being hosed by the borrowing rate by prime brokers for rehypothecation |

HenryQ |
If a put option is overvalued, it must be that the underlying is undervalued, hence sell put, long underlying and then short it for some money. |

dblueroom |
HenryQ - I disagree. put is overpriced in the market, sell it, then we have an obligation to purchase it from the buyer (of the put) at specified exercise price upon expiration. we want to cancel that long position with a short position right now. The put is overpriced, because the market is over pessimistic about the underlying, which will further depresses the price, which justifies the short position now. |

bubuiuhiuhiu |
If the value of the underlying skyrockets, the put expire worthless, you get to keep the premium, but the short underlying will suffer heave loss. How can you call that arbitrage ? |

DCPWS |
I think bubui is right. Anyone? |

jimmyvo |
Close the short underlying the same time the Put Option expires/liquidated. |