FRM Part I · FRM Exam Part I · Binomial Trees
In a one-step binomial model, a trader finds that a call trades above its no-arbitrage value from the tree. Which action exploits this?
Sell the overpriced call and buy the replicating portfolio of delta shares financed by borrowing. The replicating portfolio costs less and offsets the call payoff in both states, locking in the difference as riskless profit.
- ABuy the call and buy delta shares
- BSell the call and buy delta shares, financing with borrowing as neededCorrect
- CSell the call and short delta shares
- DBuy the call and short delta shares, investing the proceeds
Explanation
If the call is overpriced, sell it and hold the replicating portfolio (delta shares plus borrowing) that costs less. The payoff is perfectly offset, locking in the price difference as profit.
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