A stock index currently has a spot price of $1,100. The risk-free rate is 9%, an

Question

A stock index currently has a spot price of $1,100. The risk-free rate is 9%, and the index does not pay dividends. You observe that the 3-month forward price is $990. What arbitrage strategy would you undertake?

a. Sell a forward contract, borrow $1,100, and buy the stock index

b. Buy a forward contract, lend $1,100, and short-sell the stock index

c. Sell a forward contract, lend $1,100, and short-sell the stock index d. Buy a forward contract, borrow $1,100, and buy the stock index

e. Sell a forward contract, borrow $1,100, and short-sell the stock index

Explanation / Answer

fair price of 3 month forward=1100*(1+9%)^(3/12)=1123.956
As forward is undervalued at 990, we should buy forward and sell the stock
b. Buy a forward contract, lend $1,100, and short-sell the stock index

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