Consider a 1year futures contract on an investment asset tha

Consider a 1-year futures contract on an investment asset that provides no income. It costs $2 per unit to store the asset, with the payment being made at the beginning of the year. Assume that the spot price is $400 per unit and the risk free rate is 10% per annum for all maturities. b) If currently the bid and ask on this 1-year futures contract are $444.5 and $445 respectively, what will you do? Please be specific and describe what this would mpy jris asset provides a lump sum income distribution mid year that you forgot to estimate in a above would you still be confident about your suggestion in b? Please explain (C is the important question, so please elaborate on this question)

Solution

b) Future Value = (S + PV of Storage Cost)(1 +R)^t

                         = (400+ 2) (1+0.10)¹

                         = $ 442.20

Since the fair value is 442.20 while the market price is 445, I would carry cash and carry arbitrage.

I would borrow in the cash market $ 400 at risk free interest rate 10 % for 1 year. With $ 400 I would purchase in the spot market, and enter into a contract to deliver futures contract at the end of 1 year for $ 445. After 1 year I have to return the borrowed money plus interest plus the storage cost amounting to $ 442.20. After selling the futures contract for $ 445, I make a riskless profit of 445 -442.20 = $ 2.80

c) No if the asset provides an income in the mid-year I have to subtract that from the future price estimated in part b This would bring the futures price down. Hence, the strategy might not be profitable