DERIVATIVES

Arbitrage through

Making Riskless Profit

Buying something from one market and selling the same

in another Market.
Question 1

Price of share of X Ltd. in spot market is ₹ 400. Rate of interest

prevailing in money market is 10% p.a. compounded annually.
Determine the fair future price and indicate if there is any
arbitrage opportunity. If yes, determine the arbitrage strategy
and explain the process of arbitrage under the following
situations:
1.Actual Future Price for 1 year is ₹ 460.
2.Actual Future Price for 1 year is ₹ 420.
Fair Future Price (FFP) = 400 + 10% = ₹ 440

Case 1 : Actual Future Price (AFP) = ₹ 460

Arbitrage opportunity exists because AFP is not equal to FFP

AFP > FFP
In the futures market the share is over priced.
It is better to sell the shares in futures market.
In order to take the counter position, the shares should be
purchased in the spot market.

Arbitrage Strategy will be: “Buy Spot Sell Futures”

Arbitrage Process:

Step 1: Borrow ₹ 400 for 1 year at risk free rate of 10% p.a.
Step 2: Buy the share in spot market at ₹ 400.
Step 3: Enter into futures contract with a short position (i.e.
to sell) at a contracted price of ₹ 460.

After 1 year:

Step 4: Honour the futures contract and sell the share at ₹ 460.
Step 5: Repay the money market borrowings with interest
i.e. ₹ 440.
Step 6: Arbitrage Gain = Inflows as per step 4 – Outflows as per
₹ 460 - ₹ 440 = ₹ 20.
Fair Future Price (FFP) = 400 + 10% = ₹ 440

Case 2 : Actual Future Price (AFP) = ₹ 420

Arbitrage opportunity exists because AFP is not equal to FFP

AFP < FFP
In the futures market the share is under priced
It is better to buy the shares in futures market
In order to take the counter position, the shares should sell in
the spot market.

Arbitrage Strategy will be: “Sell Spot and Buy future”

Arbitrage Process:

Step 1: Step sell the stock in the spot market at ₹ 400.

(Borrow the stock for 1 year and sell the borrowed stock in the
spot market at ₹ 400).
Step 2: Invest ₹ 400 in money market at risk free interest of 10%
Step 3: Enter into futures contract with a long position (i.e. to
buy) at a contracted price of ₹ 420.
After 1 year:
Step 4: Realise investment from money market with maturity
value of ₹ 440.

Step 5: Honour the futures contract and buy the share at ₹ 420
(this is called buy to cover which is to exit the position of short
selling. The purchased share at ₹ 420 will be given back to the
stock lender).

Step 6: Arbitrage Gain = Inflows as per Step 4 – Outflows as per

₹ 440 - ₹ 420 = ₹ 20.