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CMA Final · Strategic Financial Management · Forwards and Futures

A stock trades at Rs 500. A 6-month futures contract is quoted at Rs 540. The risk-free borrowing and lending rate is 8% per annum (simple interest) and no dividends are expected. Which action produces an arbitrage profit per share, and how much is it?

Buy the stock in the spot market with borrowed money and sell the futures, earning Rs 20 per share. The fair price is Rs 520 after 6 months of interest at 8%, while the futures trade at Rs 540, so the difference is locked in.

  1. ABuy spot, sell futures; profit Rs 0
  2. BBuy spot, sell futures; profit Rs 20Correct
  3. CSell spot, buy futures; profit Rs 20
  4. DBuy spot, sell futures; profit Rs 40

Explanation

Fair futures price = 500 x (1 + 0.08 x 6/12) = 500 x 1.04 = Rs 520. Futures at 540 is overpriced, so borrow, buy spot and sell futures. Profit = 540 - 520 = Rs 20. Rs 40 ignores the financing cost of the spot purchase. Selling spot and buying futures is the reverse and applies when futures are underpriced.

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