Explanation:
First, we determine the theoretical price of the 2-year futures contract to see if an arbitrage opportunity exists. Assuming annual compounding based on the 1-year futures (2200 * 1.02 = 2244): Theoretical 2-year futures price = Spot Price × (1 + r)^2 Theoretical 2-year futures price = 2,200 × (1.02)^2 = 2,200 × 1.0404 = USD 2,288.88
The actual 2-year futures contract is trading at USD 2,295.50, which is higher than the theoretical price of USD 2,288.88. This means the 2-year futures contract is overpriced.
To execute an arbitrage strategy, you should "buy low and sell high".
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Q.49 Catherine Austin works at the arbitrage department of an investment bank. She finds that an asset is trading at USD 2,200. The price of a one-year futures contract on the asset is USD 2,244, and the price of a two-year futures contract is USD 2,295.50. Assume that the asset exhibits no cash flows in the first two years. If the term structure of interest rates is flat at 2%, which of the following would be an appropriate arbitrage strategy?
A
Short the 2-year futures, borrow USD 2,200 at 2% and buy the underlying asset
B
Buy the 2-year futures and short the underlying asset
C
Short the 2-year futures, borrow USD 2,200 at 2% and short the underlying asset
D
Buy the 2-year futures, borrow USD 2,200 at 2% and short the underlying asset
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