Question

Briefly explain what is the Spot-Futures Parity Theorem and how Arbitrage Possibilities can be exploited when this theorem is not valid. Briefly explain what is the Spot-Futures Parity Theorem and how Arbitrage Possibilities can be exploited when this theorem is not valid.

Answer 1

The Spot-Futures Parity theorem helps to evaluate price of a future contract of an asset or a stock. According to this theorem the future price of an asset should be equal to spot price adjusted for risk free interest rate, income yield (in case of asset), dividend yield (in case of stock) and the time. An asset purchased now or at a future price bears no return or risk to the investor.

Thus, according to theorem -

Future price = Spot price (1+Risk free interest rate - Income/Dividend yield)

If in case this theory doesn't withhold, then riskless arbitrage profit opportunity arises.

If the futures contract price is too high, profit is earned by taking a short position in futures and buying the asset with borrowed money at risk free interest rate.

If the futures contract price is lower than calculated future price, then profit is earned by taking a long position in the contract. Simultaneously the investor should short sell the asset and invest the proceeds at risk free interest rate.

Following the procedure, one can utilise arbitrage opportunity to earn riskless profit.

Thankyou. Hope it helps!