Question

9. The S&R index spot price is 1100, the risk-free rate is 5%, and the dividend yield on the index is 0.

a. Suppose you observe a 6 month forward price of 1135. What arbitrage would you undertake?

b. Suppose you observe a 6 month forward price of 1115. What arbitrage would you undertake?

Answer 1

9. First, let's calculate the 6 month forward price given the spot price of 1100 and risk free rate of 5%

F = Spot * e^(rt)

t = 6 months = 0.5 years

F = 1,100 * e^(0.05 * 0.5)

F = 1,100 * 1.0253151205

F = 1,127.84663255

a. Observed forward price is 1,135, which is greater than the calculated forward price. So, we sell the forward contract at the observed price of 1,135 and buy the underlying asset at the spot price of 1,100

b. Observed forward price is 1,115, which is lower than the calculated forward price. So, we buy the forward contract at the observed price of 1,115 and sell the underlying asset at the spot price of 1,100

Basically, to make an arbitrage profit, we buy the lower priced one and sell the higher priced asset at the same time