Question

Consider a single-stock futures contract on Best Buy Co. The company will pay a quarterly dividend of $0.17 per share prior to expiration of the futures contract. Consider the following scenario.

• The stock goes ex-dividend in one month; for convenience, we will assume that the dividend is paid at that time. Assume that this dividend is the only one prior to expiration of the futures contract.
• Annualized, continuously compounded risk-free interest rates: r₁ = 3% for one month, and r₂ = 4% for four months.
• Current spot price of Best Buy stock: $23 per share.
• Contract expiration: T = four months (1/3 of a year).
• Futures price on Best Buy single-stock futures: $25 per share.

Does a risk-free arbitrage opportunity exist? If so, describe the general strategy.

Group of answer choices

A. Sell shares of Best Buy short, invest at the risk-free rates, and enter a long position in Best Buy single-stock futures.

B. Sell shares of Best Buy short, invest at the risk-free rates, and enter a short position in Best Buy single-stock futures.

C. No arbitrage opportunity exists.

D. Borrow at the risk-free rates, buy shares of Best Buy, and enter a long position in Best Buy single-stock futures.

E. Borrow at the risk-free rates, buy shares of Best Buy, and enter a short position in Best Buy single-stock futures.

Answer 1

Answer :- Option A). Sell shares of Best Buy short, invest at the risk-free rates, and enter a long position in Best Buy single-stock futures.

Explanation :- There is opportunity for risk free arbitrage in the given question. Best Buy must follow a strategy as mentioned in option (A) i.e., "Sell shares of Best Buy short, invest at the risk-free rates, and enter a long position in Best Buy single-stock futures". All other options (B, C and D) to the given question are not correct.