A two year European call option, with a $140 strike price on a stock whose current value is $100, trades at $52 and a two year European put option with the same strike price trades at $86. The expected rate of return on the stock over the next year is 10%, its beta is 2.00, risk free rate is 5% and the continuous dividend yield is 2%. Assume continuous compounding in all these calculations.
1) Based on the Put-Call parity relationship is the Put option fairly priced? If not show the trading strategy, with all specific calculations, that you would setup up today to capture the profit. What are the cash flows/payoffs in two years if the stock is trading at $200?
2) What would the dividend yield need to be to assure that a Put Value of $86 is an arbitrage free price?