Lorenzo Bretscher Derivatives Spring 2023

1. A hedge fund manager is analyzing the following two assets: a non-dividend paying stock in
the IT sector listed at S0 = 95$, and a zero-coupon bond with a maturity of one year with
price B0 = 98$ and face value 100$. The following futures contracts are traded:

Underlying Futures Price Maturity

Stock 95.5$ 6 months
Bond 98.0$ 6 months

The six-month LIBOR rate is r = 0.5%.

a) Show that there are arbitrage opportunities in the market. Propose a trading strategy
that the fund’s manager could use to take advantage of arbitrage opportunities.
b) If the fund’s manager decides not to operate in the bond market and has a borrowing
constraint such that he cannot borrow more than 9, 500, 000$, what is the maximum
arbitrage profit the fund can make in the stock market using the strategy at point a)?
Suppose the hedge fund is a marginal trader and, hence, does not move the market (i.e.,
existing prices are not affected due to the fund’s trading activity).
c) The fund’s manager is offered a long position in a forward structured product with
6-month maturity for an immediate cash payment in $. The payout of the product
after three months is the difference between the current stock and bond prices, and at
maturity is the sum of the stock and bond prices. If both the stock and the bond are
now (t = 0) traded at their no-arbitrage prices, what is the no-arbitrage price of the
structured product? Assume the interest rate will be approximately constant in the next
six months, and that forward and futures prices are equivalent.

Solution

S B
a) The no-arbitrage futures prices F0,N A and F0,N A for the contracts on the stock and bond
respectively are:
S r·T
F0,N A = S0 · e = 95 · e0.005·0.5 = 95.238$
B r·T
F0,N A = B0 · e = 98 · e0.005·0.5 = 98.245$

Since the stock futures price is above the no-arbitrage price, and the bond futures price is
below the no-arbitrage price, there are arbitrage opportunities in the market. The follow-
ing strategy allows to gain sure profits and take advantage of the arbitrage opportunity
in the stock market

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Lorenzo Bretscher Derivatives Spring 2023

and the following allows to take advantage of the arbitrage opportunity in the bond
market

where ST and BT are the stock and bond prices at maturity.

b) The maximum amount the manager can borrow to implement the strategy above in the
stock market is 9, 500, 000$, that corresponds to a purchase of 100,000 shares. The profit
per share is:
F0S − S0 · er·T = 95.5 − 95.238 = 0.262$
The total profit is therefore

100000 · 0.262 = 26, 200$

c) Consider the following strategy

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where P0 is the no arbitrage price of the structured product, and S3 and B3 are the stock
and bond prices in three months respectively. By no arbitrage, P0 must be set such that
the terminal cash flow is also zero, that is

P0 = 2 · S0 = 95 · 2 = 190$