Explanation:
The theoretical 1-year forward price of corn should be: F = S × e^(r×T) = $6.90 × e^(0.08×1) = $6.90 × 1.0833 = $7.475
Since the actual forward price ($6.90) is less than the theoretical forward price ($7.475), the forward contract is underpriced. This creates a reverse cash-and-carry arbitrage opportunity.
Strategy A (Cash-and-Carry) is used when the forward is overpriced (F > S×e^(rT)). Since the forward here is underpriced, Strategy A would not produce an arbitrage profit and would actually result in a loss.
Strategy B is the correct strategy for a underpriced forward (reverse cash-and-carry):
$6.90 → receive $6.90 cash$6.90 at the risk-free rate of 8% for 1 year$6.90At expiration (1 year later):
$6.90 × e^(0.08×1) = $7.475$6.90Arbitrage profit = $7.475 − $6.90 = $0.575 per corn bushel
Therefore, Strategy B is the correct arbitrage strategy.
Q.814 Branden Berger is an active trader at Eclipse Funds. He has been closely monitoring the spot prices and forward prices of corn bushel for a long time. He has noticed that the spot price and the 1-year forward price of a corn bushel contract are identical at $6.90 per corn bushel. If the risk-free rate is 8%, then which of the following strategy will earn him arbitrage profit?
A
Borrow the amount equal to the spot price of corn for 1 year at the risk-free rate of 8%, buy a corn bushel at the spot price, and take a short position in a 1-year corn forward contract. At the expiration of the contract, the investor will sell the corn bushel at the futures price and pay off the borrowed money with interest.
B
Borrow the amount equal to the spot price of the corn bushel, lend the money for one year at the risk-free of 8%, and take a long position in a corn forward contract. After one year, the investor will receive the lent money with interest, receive the corn bushel at the expiration of the contract, and deliver the corn bushel.
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