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Let S = $100, K = $95, r =8%, T = 0.5, and δ = 0. For simplicity, let u = 1.3, d = 0.8 and n = 1 (that is, 1 period).
a. Construct the binomial tree. What is the price of a European call?
b. (i) Suppose you observe a call price of $17. What arbitrage action you will undertake? What is the arbitrage profit?
(ii) Suppose you observe a call price of $15.50. What arbitrage action you will undertake? What is the arbitrage profit?
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