To initiate an arbitrage trade if the futures contract is overpriced, the trader

Question

To initiate an arbitrage trade if the futures contract is overpriced, the trader should:

borrow at the risk-free rate, short the asset, and sell the futures.

short the asset, invest at the risk-free rate, and buy the futures.

short the future, invest at the risk-free rate, and buy the asset.

borrow at the risk-free rate, buy the asset, and sell the futures.

borrow at the risk-free rate, short the asset, and sell the futures.

short the asset, invest at the risk-free rate, and buy the futures.

short the future, invest at the risk-free rate, and buy the asset.

borrow at the risk-free rate, buy the asset, and sell the futures.

Explanation / Answer

D. Borrow at the risk-free rate, buy the asset, and sell the futures

Arbitrage gain araises when we sell in futures ( at over price) and invest in spot with risk free rate as the cost of funds. Technically, intrinsic value of the future = spot + Interest @ of risk free rate. When the actual future price is more than this intrinsic value, we can have an arbitrage gain by selling the futures and buying in the spot.

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