Question #18
Reading: Reading 30 Pricing and Valuation of Forward Commitments
PDF File: Reading 30 Pricing and Valuation of Forward Commitments.pdf
Page: 8
Status: Unattempted
Correct Answer: B
Question
To initiate an arbitrage trade if the futures contract is underpriced, the trader should:
Answer Choices:
A. borrow at the risk-free rate, short the asset, and sell the futures
B. short the asset, invest at the risk-free rate, and buy the futures
C. borrow at the risk-free rate, buy the asset, and sell the futures
Explanation
If the futures price is too low relative to the no-arbitrage price, buy futures, short the
asset, and invest the proceeds at the risk-free rate until contract expiration. Take delivery
of the asset at the futures price, pay for it with the loan proceeds and keep the profit. For
Treasury bill (T-bills), shorting the asset is equivalent to borrowing at the T-bill rate.