Explanation:
The futures price of the 6-month gold contract is greater than the spot price. An investor can borrow $1,205 for six months at the risk-free rate and take a short exposure in a 6-months gold futures contract for the futures price of $1,253. After six months, he can sell gold at the futures price of $1,253 and pay the borrowed money with interest for $1,240.62. The cash-and-carry arbitrage profit is equal to $1253 - $1240.62 = $12.38.
Borrowed fund = $1,205(1.06)^{0.5} = 1,240.62$
Section: Financial Markets and Products
Chapter: Commodity Forwards and Futures
Learning Objective: Describe an arbitrage transaction in commodity forwards and compute the potential arbitrage profit.
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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.