Question

The price of gold is currently $600 per ounce. The forward price for delivery in one year is $800. An arbitrageur can borrow money at 10% per annum. What should the arbitrageur do? Assume that the cost of storing gold is zero and that gold provides no income. Draw the cash flow of this portfolio.

Answer 1

Arbitrageur should purchase gold. If she borrows $600 for buying an ounce of gold, with rate of interest being 10%, she will have to pay $600 as principal repayment and 600 x 10% = $60 as interest after one year. However when she short a future contract, she will be receiving $800 after one year when it is sold. Hence her profit will be $800 - $600 - $60 = $140 an ounce. The return on this contract is 200/600 = 33.33% which is greater than the rate of borrowing.

Time 0: $600

Time 1: $800