Explanation:
The correct arbitrage strategy is D because:
$1,000 × e^{0.02×1} = 1,020.20$$1,000 × e^{0.02×2} = 1,040.81$Since the 2-year futures contract is overvalued compared to its theoretical price, we can execute a cash-and-carry arbitrage:
At maturity (2 years):
$1,000 × e^{0.02×2} = 1,040.81$$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