Explanation:
Scenario I will generate a profit, and scenario II will generate a loss.
Scenario I (Profit): If the forward price of the stock is higher than the current (no-arbitrage) price, the investor can borrow funds at the risk-free rate to buy shares at the current price and short forward contracts to sell the asset at the higher forward price. This strategy allows the investor to earn a risk-free return. The investor is essentially locking in a higher selling price for the shares in the future, which, if the shares are bought at a lower price now, will result in a profit. This is a classic example of arbitrage, where the investor takes advantage of price discrepancies in different markets to make a risk-free profit.
Scenario II (Loss): If the current price of a stock is higher than the forward price, the investor would need to short the shares now, invest the proceeds at the risk-free rate, and use the proceeds to take a long position in the forward contract. However, this strategy would not result in a profit because the investor would be buying high (current price) and selling low (forward price), which is the opposite of the profit-making strategy of buying low and selling high. Therefore, Scenario II will generate a loss, making Choice A the correct answer.
Q.669 Kevin Rodriguez is a candidate for the position of a junior trader at a mid-sized investment bank in Mexico. The bank's hiring process is rigid, consisting of 1 written exam and 2 interviews. Rodriguez has cleared the written exam and is currently being interviewed by the recruitment committee. The committee asked Kevin to describe the situation where an investor can make a risk-free profit on a forward contract. Kevin presented the following two scenarios:
I. If the forward price of the stock is greater than the current price, the investor can profit by purchasing shares at the current price and shorting shares at the forward price.
II. If the current price of the stock is greater than the forward price, the investor can profit by purchasing shares at the current price and shorting shares at the forward price.
Assuming that the forward price being considered differs from the forward price implied by the spot price and the current interest rate, which of the above-mentioned scenarios will generate profit?
A
Scenario I will generate a profit, and scenario II will generate a loss
B
Scenario I will generate a loss, and scenario II will generate a profit
C
Scenario I will generate a profit, and scenario II will also generate a profit
D
Scenario I will generate a loss, and scenario II will also generate a loss
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