An options exchange has a number of European call and put options listed for trading on GEMCO stock. You have been paying close attention to two put options on GEMCO, one with an exercise price of $40 and the other with an exercise price of $42. The former is currently trading at $2.20 and the latter at $4.50. Both options have a remaining life of six months. The current price of GEMCO stock is $41 and the risk-free rate is 4% p.a., continuously compounded.
Explain the arbitrage strategy you would employ to exploit this situation to earn risk-free profits. You should assume that you can borrow or lend at the risk-free rate, short sell shares if necessary and do not face any transaction costs.