Answer: Short 2-year futures contracts and long the underlying asset funded by borrowing for 2 years at 2% per year

The correct answer is D. The trader should short the 2-year futures contracts and long the underlying asset funded by borrowing for 2 years at 2% per year. This strategy is based on the principle that the futures price should reflect the cost of carrying the asset until the delivery date, which includes the cost of borrowing the funds to purchase the asset and the expected cash flows from holding the asset. In this scenario, the trader observes that the current 2-year futures price is USD 1,045, which is higher than the theoretical price calculated using the flat term structure of risk-free interest rates at 2% per year. The theoretical price for the 2-year futures contract is calculated as follows: \[ \text{Theoretical 2-year futures price} = \text{Spot price} \times e^{\text{risk-free rate} \times \text{time to maturity}} \] \[ 1,000 \times e^{0.02 \times 2} = 1,040.81 \] Since the market price of the 2-year futures contract is higher than the theoretical price, the trader can exploit this mispricing through arbitrage. The arbitrage strategy involves: 1. Selling (shorting) the overvalued 2-year futures contract at the market price of USD 1,045. 2. Borrowing USD 1,000 at the risk-free rate of 2% for 2 years. 3. Using the borrowed funds to purchase the underlying asset at its current spot price of USD 1,000. 4. Holding the asset for 2 years, during which the trader will incur interest costs on the borrowed funds. At the end of the 2-year period, the trader will: 1. Sell the underlying asset for its then-current market price, which is expected to be at least USD 1,045 (the price of the shorted futures contract). 2. Repay the borrowed funds along with the interest accrued over 2 years, which would be USD 1,000 \* e^(0.02\*2) = USD 1,040.81. The profit from this arbitrage strategy is the difference between the market price of the 2-year futures contract and the total cost of borrowing and holding the asset: \[ \text{Profit} = \text{Market price of 2-year futures} - (\text{Spot price} + \text{Interest on borrowing}) \] \[ \text{Profit} = 1,045 - (1,000 + 1,040.81) = USD 4.19 \] This arbitrage opportunity allows the trader to lock in a risk-free profit of USD 4.19, assuming no other costs or changes in market conditions.

Author: LeetQuiz Editorial Team