Question

You have the following market data.

• Spot price of the British pound is $1.5720.
• The underlying asset for the British pound futures contract is 62,500 pounds.
• 3-month British LIBOR rate is 1.38% per year, and 3-month U.S. LIBOR rate is 0.50% per year. Both rates are continuously compounded.
• British pound futures contract that expires in 3 months has a futures price of $1.5713.

What is the general arbitrage strategy?

A. Take a long position in the futures contract, borrow pounds at the British risk-free rate, sell pounds in the spot market, and invest the sales proceeds at the U.S. risk-free rate.

B. Take a short position in the futures contract, buy pounds in the spot market, borrow at the U.S. risk-free rate to finance the purchase, and invest pounds at the British risk-free rate.

C. Take a long position in the futures contract, buy pounds in the spot market, borrow at the U.S. risk-free rate to finance the purchase, and invest pounds at the British risk-free rate.

D. Take a short position in the futures contract, borrow pounds at the British risk-free rate, sell short pounds in the spot market, and invest the sales proceeds at the U.S. risk-free rate.

E. No arbitrage opportunity currently exists.

Answer 1

price of futures should be=1.572*e^(3/12*(0.5%-1.38%))=$1.568545

As futures is higher than the fair value, we should sell or short futures

B. Take a short position in the futures contract, buy pounds in the spot market, borrow at the U.S. risk-free rate to finance the purchase, and invest pounds at the British risk-free rate.