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NISM Certifications · NISM-Series-VIII: Equity Derivatives · Introduction to Forwards and Futures

A futures contract is trading at a price below its theoretical cost-of-carry value. Which action captures the arbitrage?

When futures trade below fair value, the arbitrageur buys the futures, short sells the underlying stock and invests the sale proceeds. This reverse cash-and-carry locks in the gap at expiry when futures and spot converge. The opposite trade is used when futures are overpriced.

  1. ABuy futures and sell the stock short, keeping proceeds investedCorrect
  2. BSell futures and buy stock with borrowed funds
  3. CBuy stock and buy futures
  4. DSell both stock and futures

Explanation

If futures are underpriced relative to fair value, a reverse cash-and-carry is used: buy the cheap futures, short-sell the expensive spot and invest the proceeds at the risk-free rate. Selling futures and buying stock is the cash-and-carry used when futures are overpriced.

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