Question

Suppose that the risk-free interest rate is 8% per annum with continuous compounding. The dividend yield on a stock is 3.5% per annum. The stock currently is selling at $255.17 and the futures price for a contract deliverable in five months is $270.

a. Is there an arbitrage opportunity?

(sample answer: yes; or no)

b. If there is an arbitrage opportunity, then will you long futures or short futures?

(sample answer: Long; or Short)

c. What is the arbitrage profit per share if there is an arbitrage opportunity in today’s dollar (PV of the profit) ignoring the transaction fee?

(sample answer: $1.25)

Answer 1

a)YES

The theoretical future price is= The actual futures price is only 270. This shows that the index futures price is too low relative to the index. The correct arbitrage strategy is Buy futures contracts Short the shares underlying the index.

b)Long

c)