Explanation

To identify the arbitrage opportunity, we need to calculate the theoretical futures prices and compare them with the actual market prices.

Given:

• Spot price (S) = USD 1,000
• 1-year futures price = USD 1,010
• 2-year futures price = USD 1,025
• Risk-free rate (r) = 1% per year (annually compounded)
• No cash flows from the asset

Step 1: Calculate theoretical futures prices

For no-dividend assets, the theoretical futures price is: $F = S \times (1 + r)^T$

1-year theoretical futures price: $F_{1yr} = 1,000 \times (1.01)^1 = 1,010$

2-year theoretical futures price: $F_{2yr} = 1,000 \times (1.01)^2 = 1,000 \times 1.0201 = 1,020.10$

Step 2: Compare theoretical vs actual prices

• 1-year futures: Theoretical = 1,010, Actual = 1,010 → No arbitrage
• 2-year futures: Theoretical = 1,020.10, Actual = 1,025 → Overpriced by 4.90

Step 3: Identify arbitrage strategy Since the 2-year futures contract is overpriced (1,025 > 1,020.10), we should:

• Short the 2-year futures contract (sell overpriced asset)
• Long the underlying asset (buy the actual asset)
• Fund the purchase by borrowing for 2 years at 1% interest

Step 4: Verify the arbitrage profit

• Borrow USD 1,000 for 2 years at 1% → Repayment = 1,000 × (1.01)² = 1,020.10
• Buy the asset for USD 1,000
• Short the 2-year futures contract at USD 1,025
• After 2 years: Sell the asset through futures at USD 1,025
• Profit = 1,025 - 1,020.10 = 4.90 (risk-free profit)

Therefore, Option C is the correct arbitrage strategy.