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Finance Quant Interview - I

The Put option on the $40 strike is priced at $10.
The Put option on the $30 strike is priced at $8.

Is there an arbitrage opportunity?

Note by Calvin Lin
1 year, 10 months ago

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No, since P(40)-P(30)=2<40-30=10. Gary Lai · 1 year, 5 months ago

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@Gary Lai You do not have a proof that there is no arbitrage opportunity. You have only checked one particular condition. There are more conditions to check. For example, an obvious one should be that P(30) < P(40). If that were not true, then we could arbitrage. Calvin Lin Staff · 1 year, 5 months ago

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@Calvin Lin Well, there are really only 2 inequalities to check. First of all, assuming \(K_{1}<K_{2}\), \(P(K_{1})<P(K_{2})\) and \(P(K_{2})-P(K_{1})\leq K_{2}-K_{1}\), since the premium for a put option increases more slowly compared to the strike price increase. If there are 3 options then we will have to compare its convexity. Gary Lai · 1 year, 5 months ago

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@Gary Lai Great analysis! I question your assumption of "there are only 2 options given".

In particular, what is the put option on the 0 strike worth? Calvin Lin Staff · 1 year, 5 months ago

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@Calvin Lin It will be zero. Gary Lai · 1 year, 5 months ago

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@Gary Lai Precisely. Now, since I've demonstrated that the assumption of "only 2 option values" is not true, you should apply your comment of "If there are 3 options, then we will have to compare its convexity", and see what happens from there. Calvin Lin Staff · 1 year, 5 months ago

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@Calvin Lin It forms another inequality! Although I still think that there is no arbitrage opportunity here, since Put option with 0 strike price wont exist. Gary Lai · 1 year, 5 months ago

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Interesting question. Finally solved it.

Yes. There is an arbitrage opportunity. Buy \( x \) 40$ Put options and sell \( y \) 30$ Put options where \( 12y > 15x > 11 y \) Siddhartha Srivastava · 1 year, 10 months ago

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@Siddhartha Srivastava To check if it works.

Like you said, \( x = 7 , y = 9 \) works. So we buy 7 puts (A) for $70 and sell 9 puts (B) for $72. Total profit now, = $72 - 70$ = 2$

If stock price is above 40; both put options remain unused. Total earning 2$

If stock price is \( X = (30,40) \); we use the 7 puts (A) for profit = 7(40-x) > 0; 9 (B) puts remain unused.. Total earning = 2$ + 7(40-x)> 2$

If stock price is \( X = (0,30) \); we use the 7 puts (A) for profit = 7(40 - X); 9 (B) puts are used giving a loss = 9(30 - X). Total earning = 7(40-X) -9(30-X) + 2$ = 2X + 12$ > 0 Siddhartha Srivastava · 1 year, 9 months ago

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@Siddhartha Srivastava Assume that the $40 put is still priced at $10.

What would be the price of the $30 put option, where there will be no arbitrage opportunity? Calvin Lin Staff · 1 year, 9 months ago

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@Calvin Lin Let the price at which the 30$ put options is priced be \( M$ \).

Now suppose that an arbitrage opportunity does exist. It is easily proved that the arbitrage opportunity(AO) must consist of buying 40$ (A) put options and selling 30$ (B) put options. Let x (A) puts be bought and y (B) puts be sold for the AO.

So we spend \( 10x$ \) for the (A) puts and gain \( My$ \) for the (B) puts. Total gain =\( My - 10x \)

If the stock price is above 40; both puts remain unused. Therefore net earnings = \( My - 10x. \) Since earning is greater than 0 in an AO, \( My - 10x \geq 0 \implies My > 10x \implies (30-M)My > 10(30-M)x \). Also, since \( M < 10 \), we have \( y > x \)

If the stock price is \( = P = (0,30) \); both puts are used. Earning on (A) puts = \( x(40 - P) \). Loss on B puts\( = y(30 - P). \) Total earning = \( x(40 - P) - y(30-P) + My - 10x = 30x - (30 - M)y + (y-x)P \)

Since \( y - x > 0 \). Total earning is minimum when \( P = 0 \).

So minimum total earning \( = 30x - (30 - M)y \geq 0 \implies 30x \geq (30-M)y \implies 30Mx \geq M(30 -M)y \).

Combining both inequalities, \( 30Mx \geq (30 -M)y \geq 10(30-M)x \).

\( \implies 30Mx \geq 10(30 -M)x \implies 40M \geq 300 \implies M \geq 7.5 \)

So in an AO does exist, \( M \geq 7.5$ \). Therefore, if \( M < 7.5$ \), than an AO does not exist. Siddhartha Srivastava · 1 year, 9 months ago

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When you pay the $10, your net gain is 40-10 = 30 which is better than 30-8=22

So, probably yes Agnishom Chattopadhyay · 1 year, 10 months ago

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@Agnishom Chattopadhyay How is the net gain 40-10=30? Are you assuming that the stock is worth 0 at the end?

What is the value of "strike - put price" equal to? How does that graph (against strikes) look like? Should it be lower for lower strikes? Calvin Lin Staff · 1 year, 10 months ago

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