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CFA Level I · CFA Level I Exam · Valuing a Derivative Using a One-Period Binomial Model

In a one-period binomial model, an analyst finds that the price of a call option in the market is higher than the value obtained by constructing a portfolio of the underlying and a risk-free bond that replicates the call payoffs. The arbitrageur's most appropriate action is to:

The arbitrageur should sell the call and buy the replicating portfolio. The call is overpriced relative to the cost of replicating its payoffs, so selling it and buying the cheaper replica captures the price difference today while the payoffs offset at expiration, leaving no risk.

  1. Asell the call and buy the replicating portfolioCorrect
  2. Bbuy the call and buy the replicating portfolio
  3. Cbuy the call and sell the replicating portfolio

Explanation

If the call trades above the cost of its replicating portfolio, it is overpriced. The arbitrageur sells the expensive call and buys the cheaper replicating portfolio, locking in the difference today with offsetting payoffs at expiration. Buying the call would add to the overpriced position.

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