finance arbitrageurs

Arbitrageurs are always looking for mispriced securities in the market. Sometimes the easiest way to find

 

pricing discrepancies is to look for pairs of securities that are mispriced relative to each other. (When

 

you identify two securities that are mispriced relative to each other, you don’t have to worry about

 

what the actual price of each of the securities should be.). Your roommate tells you that he found

 

two put options on the same non-dividend paying stock that may be mispriced. In particular, the

 

one with the higher exercise price is selling at a lower price.

 

Design a trading strategy that takes advantage of the mispricing. Using the payoff and profit tables

 

and graphs from class, show that your strategy is always profitable no matter what happens to the

 

stock price. Also show that the strategy has zero cost and zero risk.

 

 

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