Question

Why C is not correct?

Suppose you have the following information available to you. A forward contract on the Euro written at a rate of 1.60 AUD/EUR and a futures contract on the Euro written at a rate of 1.65 AUD/EUR. Suppose the former expires on the 22nd of November whereas the latter expires on the 22nd September. Which of the following is most correct? Assume that both contracts are written on the same amount of Euro.

A) a trader can make a riskless profit by taking a short position in the forward contract and a long position in the futures contract. This profit is equal to 0.05 AUD/EUR per contract

B) The trader can make a riskless profit but it may not necessarily equal 0.05 AUD/EUR per contract due to transaction costs

C) Whilst the trader may be able to profit, it is not a riskless profit because the forward contract obligates him to deliver Euro on 22nd September and he will not receive Euro until 22nd November

D) None of the above is correct

Answer 1

None of the statements is correct here. It is because though the trader can make a profit, it will not be a riskless one and it will not necessarily equal to 0.05 AUD/EUR. The reason for the profit not being riskless is not because of the delivery issue. If he has to deliver the currencies, he would never be able to pay in September because he will be getting the Euro in November. The issue here is not of delivery but of price. The trader will never like to take or give delivery because not only that process is long but also here he wouldn't have the currency to deliver. Hence, he would want to make some portion of the spread of 0.05 AUD/EUR. He has gone long on the lower exchange rate and short on the higher hoping to gain this spread. In order to gain this spread, he would hope that by the time the first expiry comes, the prices of the two contracts come close i.e. the spread would decrease. The reduction in the spread is expected because as expiry approaches the futures and forward prices approach the spot prices. This reduction is expected but not guaranteed. It might also happen that the spread remains the same or increases (less likely). Hence, this is the reason of the trade not being riskless. Option D is correct.