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Suppose the 1-year futures price on a stock-index portfolio is 1914; the stock-index is currently 1900;...

  1. Suppose the 1-year futures price on a stock-index portfolio is 1914; the stock-index is currently 1900; the 1-year risk-free interest rate is 3%; and the year-end dividend that will be paid on a $1,900 investment in the market index portfolio is $40.
  1. By how much is the contract mispriced?
  2. Formulate a zero-net-investment arbitrage portfolio and show that you can lock in riskless profits equal to the futures mispricing. Show your strategy in a table outlining the initial and terminal values of your strategy
  3. Now assume (as is true for small investors) that if you short sell the stocks in the market index, the proceeds of the short sale are kept with the broker, and you do not receive any interest income on the funds. Is there still an arbitrage opportunity (assuming that you do not already own the shares in the index)? Explain and detail your answer in a table

d) Given the short-sale rules, what is the no-arbitrage bond for the stock-futures price relationship? That is, given a stock index of 1,900, how high and how low can the futures price be without giving rise to arbitrage opportunities?

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