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

## 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.

Author: LeetQuiz .