Stock Index Arbitrage

Question 1

Overvalued futures

Answer 1

F0,T > S0(1+RFR -D)^T
- short index futures
- long index at spot price
- borrow at RFR (this funds the long index position)
- net CF: F0,T - S0(1+RFR)^T + D

Question 2

Undervalued futures

Answer 2

F0,T < S0(1+ RFR -D)^T
- long index futures
- short index at spot price
- lend/invest at RFR
- net cash flow = S0(1+RFR)^T - D(T) - F0,T

Question 3

Eurodollar contracts

Answer 3

anticipating LIBOR will fall → long Eurodollar contracts

anticipating LIBOR will rise → short Eurodollar contracts

Question 4

FRAs (forward rate agreements)

Answer 4

First number tells us when the contract matures and the second number tells us when we’ll get paid. the difference between the numbers tells us the length of the LIBOR i.E. 3 months LIBOR

Question 5

Expect LIBOR (floating) will increase

Answer 5

BUY (long) FRAs → trade fixed rate and receive LIBOR

• (LIBOR - Fixed Rate)
• use cap settlement but remember it’s RECEIVES LIBOR

Question 6

Expect LIBOR (floating) to decrease

Answer 6

• sell (short) FRAs

(Fixed Rate - LIBOR ⬇️)
- use floor settlement and remember it’s PAYS

Question 7

Spot-Futures parity

Answer 7

if an asset can be purchased today and held until the exercise of a futures contract, the value of the future should equal the current spot price adjusted for the cost of money, dividends, “convenience yield” and any carrying costs

If spot-futures parity is not observed then arbitrage is possible