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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 is because the current 2-year futures price in the market (USD 1,045) is overvalued compared to the theoretical price (USD 1,040.81) calculated using the formula \(1,000 * e^{0.02 \times 2}\). By shorting the 2-year futures and borrowing USD 1,000 at 2% for 2 years, the trader can buy the underlying asset. At the end of the 2nd year, they would sell the asset at the market price of USD 1,045 and return the borrowed amount with interest, which would be \(1,000 * e^{0.02 \times 2} = 1,040.81\). This results in a gain of USD 4.19. The other options (A, B, and C) are incorrect as they do not provide an arbitrage opportunity based on the given information and assumptions.
Author: LeetQuiz Editorial Team
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A financier specializing in statistical arbitrage at an international banking institution observes the following details about a particular monetary instrument: The instrument is currently priced at $1,000. The cost of a 1-year futures contract on this instrument is $1,020, and the cost of a 2-year futures contract is $1,045. The financier assumes that there will be no cash flows from the instrument over the next 2 years. Given that the term structure of risk-free interest rates remains constant at 2% per annum, what would be an appropriate arbitrage strategy?
A
Short 1-year futures contracts and long 2-year futures contracts
B
Short 2-year futures contracts and long 1-year futures contracts
C
Short 1-year futures contracts and long the underlying asset funded by borrowing for 1 year at 2% per year
D
Short 2-year futures contracts and long the underlying asset funded by borrowing for 2 years at 2% per year
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