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Explanation:
First, calculate the theoretical futures price to determine if the futures contract is overpriced or underpriced.
Using the continuous compounding formula:
The quoted futures price () is $1253.
Since the quoted futures price ($1253) is greater than the theoretical futures price (~$1241.70), the futures contract is overpriced.
To exploit this "cash-and-carry" arbitrage opportunity, the trader should:
Option D accurately describes this cash-and-carry arbitrage strategy.
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Q.18 A commodity trader at an investment bank has analyzed the forward prices of gold contracts and realized that there might be an arbitrage profit opportunity present in gold futures contracts. The spot price for one ounce of gold is $1,205, and a 6-month futures contract is quoted as $1,253 per ounce. If the risk-free rate is 6%, what steps should the trader take to realize arbitrage profit?
A
Borrow the amount equal to the futures price of gold for six months at the risk-free rate and take a short exposure in a 6-month gold futures contract. At the contract's expiration, sell the gold at the futures price and pay the borrowed money with interest.
B
Short sell gold today and take a long position in a 6-month gold futures contract. Then, lend the money at the risk-free rate for six months. At the contract's expiration, receive the money with interest and buy back gold at the futures price and deliver the gold.
C
Short sell gold today and take a long position in a 6-month gold futures contract. Borrow money at the risk-free rate for six months. At the contract's expiration, receive the money with interest and buy back gold at futures price and deliver the gold.
D
Borrow the amount equal to the spot price of gold for six months at the risk-free rate to buy gold in the spot market and take a short exposure in a 6-month gold futures contract. At the contract's expiration, sell gold at futures price and pay the borrowed money with interest.