CFA Practice Question

There are 206 practice questions for this study session.

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.

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.
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