8. What should a trader do when the one-year forward price of an investment asse

Question

8. What should a trader do when the one-year forward price of an investment asset is too low? Assume that the asset provides no income A. The trader should borrow the price of the asset, buy one unit of the asset and enter into a short forward contract to sell the asset in one year B. The trader should borrow the price of the asset, buy one unit of the asset and enter into a long forward contract to buy the asset in one year C. The trader should short the asset, invest the proceeds of the short sale at the risk-free rate, enter into a short forward contract to sell the asset in one year D. The trader should short the asset, invest the proceeds of the short sale at the risk-free rate, enter into a long forward contract to buy the asset in one year E. Do nothing

Explanation / Answer

D is correct.

As the forward price of the asset is low. A trader should exploit the arbitrage opportunity to short the asset in the spot market and buy in the forward market. The proceeds from the short should be invested at risk-free rate.

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