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

If the actual futures price is higher than the theoretical fair value determined by the cost of carry model, which arbitrage action is appropriate?

The arbitrageur should sell the overpriced futures and buy the underlying in the spot market, holding until expiry. This cash-and-carry trade locks in a risk-free profit because futures and spot prices converge at maturity.

  1. ABuy futures and sell the underlying in the spot market
  2. BSell futures and buy the underlying in the spot market, holding until expiryCorrect
  3. CBuy both futures and the underlying
  4. DSell both futures and the underlying

Explanation

When futures are overpriced relative to fair value, an arbitrageur does cash-and-carry: buy spot, finance it, and sell the expensive futures, locking in a risk-free profit at expiry when prices converge. The reverse applies when futures are underpriced.

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