If the observed put option premium is less than what is suggested by the put-call parity equation, astute arbitrageurs could make a profit by ____ the put option, ____ the call option, and ____ the underlying currency.
A) selling; buying; buying
B) buying; selling; buying
C) selling; buying; selling
D) buying; buying; buying

Question

Quizplus · Accepted Answer

According to put-call parity, the premium of a European put option should be equal to the premium of a European call option with the same strike price and expiration date minus the present value of the strike price discounted to the present. If the observed put option premium is less than what is suggested by put-call parity, it means the put option is undervalued and can be bought at a lower price than its theoretical value. At the same time, the call option can be sold at its theoretical value, and the underlying currency can be bought at its current market price. By doing so, arbitrageurs can lock in a riskless profit since the cost of buying the put, selling the call, and buying the currency is lower than the expected payoff at expiration. Therefore, the correct option is to buy the put option, sell the call option, and buy the underlying currency, which is represented by choice letter B.

If the Observed Put Option Premium Is Less Than What