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user72180
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Call option arbitrage oppotrunity

I am having trouble wrapping my head around some text provided to us by our lecturer (unfortunately he is currently unavailable). If we let $c$ be the price of a European call option, $S_0$ the current price of an asset (say a stock), $X$ the strike price, $T$ the time to maturity, and $r$ the (static) interest rate. We ignore dividends.

Suppose that $$c = 3, S_0 = 20, X = 18,\\ T = 1, r = 10\%$$ Is there an arbitrage opportunity?

  • buy the call, short the stock
  • proceeds: $-3+20 =17$; grows to $17e^{0.1} = 18.79 > 18$
  • yes!

I don't understand how you can deduce the existence of an arbitrage opportunity from $18.79 > 18$.

user72180
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