Question

In: Finance

Which arbitrage opportunity will you use to exploit the mispricing?

Given the following information

Spot = R100
Risk--free = 10%
Maturity = 1 year
Foward contract price =R80

Which arbitrage opportunity will you use to exploit the mispricing?

Solutions

Expert Solution

Arbitrage-free forward price = spot price * (1 + risk free rate)time in years

Arbitrage-free forward price = R100 * (1 + 10%)1 = R110

However, the forward contract price is R80.

An arbitrage profit can be earned by the following steps :

  • Borrow the asset and sell it in the spot market at the spot price. Simultaneously, buy the forward contract
  • Invest the sale proceeds at the risk free rate for 1 year. Amount received after 1 year = R100 * (1 + 10%) = R110
  • After 1 year, take delivery of the asset using the forward contract, and use it to cover the short sale.
  • Arbitrage profit = Amount received after 1 year - amount paid on forward contract = R110 - R80 = R30

jeff jeffy answered 2 years ago
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