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My example is:

  • Current price = 20,
  • If it goes up it'll be worth 22, if it goes down it will be worth 18
  • risk free rate: 12%, time = 3 months
  • Strike = 21
  • call option is worth 0.633

I know that if the call option value is less than 0.633 then there's an opportunity for arbitrage but what about if the option is being sold in the market at 0.7? What strategy is used in this case?

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    $\begingroup$ Maybe add more context as to where you're having trouble. You did you show the arbitrage in the case that the option price is less than $0.663?$ The case where it's greater is similar only of course you sell the option rather than buying it. $\endgroup$ – spaceisdarkgreen Sep 30 '17 at 23:40
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Hint: Put call parity. We are supposed to have

$$C = P+S-D \cdot K$$

So if instead $C > P+S-D \cdot K$, then the arbitrage profit should be $C - (P+S-D \cdot K)$.

So what do you do with the call option? Long? Short? I guess it's the opposite position of what you used when $C < P+S-D \cdot K$

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