In: Finance
A stock is currently priced at $40. The risk-free rate of interest is 8% p.a. compounded continuously and an 18-month maturity forward contract on the stock is currently traded in the market at $38. You suspect an arbitrage opportunity exists. Which one of the following transactions do you need to undertake at time t = 0 to arbitrage based on the given information?
a)Long the forward, borrow money and buy the share
b)Short the forward, short-sell the share and invest at risk-free rate
c)Long the forward, short-sell the share and invest at risk-free rate
d)Short the forward, borrow money and buy the share
formula for arbitrage free futures price is
F = s×e^rt
Where s is spot rate
R is rate
= 40×e^(0.08)×1.5 = 45
But actual price is 38
as the actual rate is less than arbitrage free rate arbitrage oppurtunity exixts
And arbitrage process is
Long forward short sell the spot market and invest at risk free rate
Option 3 is correct