Consider an n = 1 step binomial tree with T = .5. Suppose r, the annualized risk-free rate is 8 %, and delta, the annualized dividend rate is 7 %. Also suppose the annualized standard deviation of the continuously compounded stock return, sigma, is 45 %. Suppose further that the initial stock price, S = $ 90; and that the strike price K is $ 122. Suppose you observe a put price of $ 32.288, which is higher than the price for the European put option that you computed using the 1-step binomial tree method. By using the arbitrage method outlined in the book, that is, buying a synthetic put option and selling the actual put option:
a) Determine the European put premium
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b) Determine the number of shares of stock that you'll sell
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c) Determine the amount of money that you'll lend
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d) Determine the risk free profit from this arbitrage opportunity
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You can earn partial credit on this problem.