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How arbitrages earn riskless Profit? Give Example? |
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Answer» The cost-of-carry ensures that the futures price stay in tune with the spot price. Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. Say for instance, ABC Ltd. trades at Rs.1000. One-month ABC futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions. 1. On day one, borrow funds, buy the security on the cash/spot market at 1000. 2. Simultaneously, sell the futures on the security at 1025. 3. Take delivery of the security purchased and hold the security for a month. 4. On the futures expiration date, the spot and the futures price converge. Now unwind the position. 5. Say the security closes at Rs.1015. Sell the security. 6. Futures position expires with profit of Rs. 10. 7. The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures position. 8. Return the borrowed funds. |
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