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CFA Level I · CFA Level I Exam · Pricing and Valuation of Forward Contracts and for an Underlying with Varying Maturities

A trader observes that the market forward price of an asset paying no income is higher than the spot price compounded at the risk-free rate for the contract term. The most appropriate arbitrage strategy is to:

The trader should borrow at the risk-free rate, buy the asset, and sell the forward contract. Delivering at the overpriced forward price more than repays the loan, producing a riskless profit. This is the cash-and-carry arbitrage.

  1. Abuy the asset with borrowed funds and sell the forward contractCorrect
  2. Bsell the asset short, lend the proceeds, and buy the forward contract
  3. Cbuy the forward contract and invest in the risk-free asset

Explanation

When the forward is overpriced, buy the asset at spot financed by borrowing at the risk-free rate and sell the forward. At expiry deliver the asset at the high forward price and repay the loan, locking in a riskless profit. The second option is the strategy for an underpriced forward.

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