Question

You enter into a forward contract on a non-dividend paying stock with maturity of 1-year, with S0 = $40 and r = 10% p.a.(simple rate). If the quoted futures price is Fq = 42 explain how you can make a risk-free arbitrage profit.

Answer 1

Arbitrage Profit =

Explanation

Sport rate = 40

Expected futures price using 10% as simple interest rate = Spot * ( 1 + Interest rate )

= 40 * ( 1 + 10% ) = 44

But the futures are quoted at 42, which means that futures are under valued. An arbitrage strategy to make risk free arbitrage profit ........ Sell in the spot market and buy in the futures market.

By selling at the spot rate, we get $40, which can be inveted at 10% to earn a simple interest of 40*10% = 4

Thus total cash inflow = 40 + 4 = $44

The same share can be acquired back using the forward contract (after one year ) at a price = 42.

Risk free arbitrage profit = 44 - 42 = $2