# Arbitrage

Document Sample

```					Practical Exercise on Arbitrage

Cash and Carry model:

1) Spot price = \$400

Futures price = \$450.

Interest = 10%.

Do we have an arbitrage opportunity?

t=0,

Borrow \$400 for 1 yr at 10%                         \$400

Buy gold in spot market for \$400                    -\$400

Sell 1 futures contract for \$450 delivery in 1 yr   \$0

Net CF= \$0

T=1,

Remove gold from storage                            \$0

Deliver gold against futures contract               \$450

Repay loan including interest                       -\$440

Net CF = \$10 (PROFIT)
Reverse C and C model

Q2) Spot = \$420, Futures price \$450, r= 10%. Do we have an arbitrage opportunity?

T=0,

Sell gold short                                 \$420

Lend \$420 for 1 yr @10%INTEREST                 -\$420.

Buy 1 futures contract for delivery in 1yr      0

Net CF= \$0

T=1,

Collect proceeds from loan (420*1.1)            \$462.

Accept delivery on futures contract             -\$450

Use gold from futures delivery to repay short sale       \$0

Net CF= \$12. (PROFIT)

C and C involving storage costs

Same question as Q1, but with storage (transaction) costs of 3%. Is there an Arbitrage opportunity?

Adjust Spot for transaction costs, i.e, New spot price = \$400(1+3%) = \$412.

Repeat whole procedure in Q1. Net cash flows in t=1  -\$3.20 (loss)

Reverse C and C involving storage costs

Same question as Q2, but with storage (transaction) costs of 3%. Is there an Arbitrage opportunity?

Adjust Spot for transaction costs, i.e, New spot price = \$420(1-3%) = \$407.40.

Repeat whole procedure in Q2. Net cash flows in t=1  -\$1.86. (loss)

```
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
 views: 7 posted: 12/8/2011 language: pages: 2