Explanation:
The no-arbitrage forward price factors in the interest cost of financing the spot and the storage costs.
U = \`2,500 \times 0.03 = \.
F = (\`2,500 + \75`) \times (1.06)^{0.5} = \`2`,651 $.
So, the forward contract is overpriced at $2,672. The arbitrageur will execute cash and carry arbitrage by selling the forward contract and buying the spot. The arbitrageur will sell the forward contract at $2,672 and borrow cash at 6%. The purchase of the spot, financing costs, and storage costs results in total costs of $2,651.
At the forward contract maturity, the arbitrageur will deliver gold against the forward contract. The riskless arbitrage profit is \`2,672 - \2`,651 = \`21` $.
(Book 3, Module 37.2, LO 37.e)
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Question 1
The spot price of gold is $2,500 per ounce. The annual interest rate is 6% and the storage costs are 3% of the purchase price. The price of a six-month gold forward contract is $2,672. What would be the appropriate arbitrage strategy?
A
Sell the forward contract, borrow cash, and buy the spot.
B
Sell the forward contract, lend cash, and buy the spot.
C
Buy the forward contract, lend cash, and sell the spot short.
D
Buy the forward contract, borrow cash, and buy the spot.
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