CFA Level I · CFA Level I Exam · Option Replication Using Put-Call Parity
When put-call parity is violated and an arbitrageur executes the correct offsetting trades, the most likely effect on market prices is that:
Arbitrage trading buys the underpriced side and sells the overpriced side, which pushes prices back toward parity. Because the positions offset, the arbitrageur holds no stock price risk, and the risk-free rate is unaffected.
- Aoption and stock prices move back toward parity as the trades are executedCorrect
- Bthe risk-free rate rises to eliminate the gap
- Cthe arbitrageur bears the stock's price risk until expiration
Explanation
Buying the underpriced portfolio and selling the overpriced one pushes prices together, removing the mispricing. The stock exposure is hedged so the arbitrageur bears no price risk. The risk-free rate is not set by this trade.
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