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

Nifty futures trade at 22,000 while the fair value from cost of carry is 21,900. Which action by an arbitrageur captures a risk-free profit?

The arbitrageur should sell the overpriced futures and buy the underlying index stocks in the cash market, holding to expiry. This cash-and-carry trade locks in the difference between the actual futures price and fair value as prices converge at expiry.

  1. ABuy futures and sell the stocks in the index in cash market
  2. BSell futures and buy the index stocks in cash market, holding till expiryCorrect
  3. CBuy both futures and the cash market stocks
  4. DSell both futures and the cash market stocks

Explanation

Futures are overpriced relative to fair value, so the arbitrageur performs cash-and-carry: buy the underlying stocks in the spot market and sell the futures, locking in the gap of about 100 points at expiry when prices converge. The reverse trade suits underpriced futures.

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