Page 117 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes 7.3.3 Arbitrage Benefits Using Futures

Arbitrage refers to riskless profit earned by taking positions in spot/futures markets.
Following are two of the primary benefits that an arbitrageur can obtain using futures contracts:
Arbitrage: Overpriced futures: Buy spot, Sell futures

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.
If you notice that futures on a security that you have been observing seem overpriced, we would
illustrate as to how to obtain riskless arbitrage profits. Say for instance, SBI trades at ` 1,000.
One–month SBI futures trade at ` 1,025 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 1,000.
2. Simultaneously, sell the futures on the security at ` 1,025.
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 ` 1015. Sell the security.

6. Futures position expires with profit of ` 10.
7. The result is a riskless profit of ` 15 on the spot position and ` 10 on the futures position.
8. Return the borrowed funds.

When does it make sense to enter into this arbitrage? If your cost of borrowing funds to buy the
security is less than the arbitrage profit possible, it makes sense for you to arbitrage. This is
termed as cash–and–carry arbitrage.

!
Caution Remember however, that exploiting an arbitrage opportunity involves trading
on the spot and futures market. In the real world, one has to build in the transactions costs
into the arbitrage strategy.

Arbitrage: Under Priced Futures: Buy Futures, Sell Spot

Whenever the futures price deviates substantially from its fair value, arbitrage opportunities
arise. It could be the case that you notice the futures on a security you hold seem under-priced.
How can you cash in on this opportunity to earn riskless profits? Say for instance, ABB trades at
` 1,000. One-month ABB futures trade at ` 965 and seem under-priced. As an arbitrageur, you can
make riskless profit by entering into the following set of transactions:
1. On day one, sell the security in the cash/spot market at ` 1,000.

2. Make delivery of the security.
3. Simultaneously, buy the futures on the security at ` 965.
4. On the futures expiration date, the spot and the futures price converge. Now unwind the
position.
5. Say the security closes at ` 975. Buy back the security.

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