- 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 lower than the price suggested by the one-period binomial model, what is the appropriate arbitrage strategy?

B. Buy the put option and short the underlying.

C. Buy the put option and long the underlying.

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.

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**User Contributed Comments**
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Comment |
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vi2009 |
for puts => long or short positions in BOTH instruments not for calls though ... |