Page 173 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 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.

Did u know? 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. 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.
2. 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 underpriced. 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 underpriced. 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.
6. The futures position expires with a profit of ` 10.
7. The result is a riskless profit of ` 25 on the spot position and ` 10 on the futures
position.
If the returns you get by investing in riskless instruments are lesser than the return from the
arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse-cash-and-carry
arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with
the cost-of-carry. As we can see, exploiting arbitrage involves trading on the spot market. As
more and more players in the market develop the knowledge and skills to do cash-and-carry
and reverse cash-and-carry, we will see increased volumes and lower spreads in both the cash as
well as the derivatives market.

Task Consider a call option on a stock with following parameters:
Strike Price = ` 70
Risk-free rate of interest = ` 6%

Time to expiration = 90 days

Contd...

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