Assume you find that the price of a futures contract is below the price given by spot-futures parity. Assuming there are no carrying charges, to make an arbitrage profit, traders will _________ in the cash market and _________ in the futures market.
A) buy; buy
B) buy; sell
C) sell; sell
D) sell; buy
E) Insufficient information.

Question

Quizplus · Accepted Answer

If the price of a futures contract is below the price given by spot-futures parity, it implies that the futures contract is undervalued. To make an arbitrage profit, a trader would sell (short) the underlying asset in the cash market and simultaneously buy (go long) the futures contract. This establishes a synthetic long position in the underlying asset. As the market approaches expiration and the futures price approaches the spot price, the trader can exit their positions and realize a profit. This strategy is known as cash and carry arbitrage. Since the question assumes no carrying charges, the trader can simply hold the underlying asset until expiration to realize the profit.

Assume You Find That the Price of a Futures Contract