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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
## Explanation The correct arbitrage strategy is **D** because: ### Theoretical Futures Pricing - The 1-year futures price should be: $1,000 × e^{0.02×1} = 1,020.20$ - The 2-year futures price should be: $1,000 × e^{0.02×2} = 1,040.81$ ### Market Analysis - Current 1-year futures price: USD 1,020 (slightly undervalued at -0.20) - Current 2-year futures price: USD 1,045 (overvalued at +4.19) ### Arbitrage Strategy Since the 2-year futures contract is overvalued compared to its theoretical price, we can execute a cash-and-carry arbitrage: 1. **Short the 2-year futures contract** at USD 1,045 2. **Borrow USD 1,000** at 2% for 2 years 3. **Buy the underlying asset** at USD 1,000 ### Profit Calculation At maturity (2 years): - Sell asset via futures contract: USD 1,045 - Repay loan: $1,000 × e^{0.02×2} = 1,040.81$ - **Arbitrage profit**: $1,045 - 1,040.81 = USD 4.19$ This strategy locks in a risk-free profit of USD 4.19 per contract.
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A trader in the arbitrage unit of a multinational bank finds that a financial asset is trading at USD 1,000, the price of a 1-year futures contract on that asset is USD 1,020, and the price of a 2-year futures contract is USD 1,045. Assume that there are no cash flows from the asset for 2 years. If the term structure of risk-free interest rates is flat at 2% per year, which of the following is 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