Chapter 2

Valuation of Forward and Futures Contracts

A futures contract, as defined earlier, is an exchange traded commitment contract.

It imposes an obligation to buy the underlying asset on the long, and an equivalent
commitment to sell the underlying asset, on the short.

Futures prices should obviously accurately reflect the price of the underlying asset,
for the former are derived from the latter. The concept of arbitrage is critical for under-
standing how spot prices and futures and forward prices are linked. If the postulated
relationship between the two prices is not satisfied, arbitrageurs will exploit the resulting
profit opportunities until they are eliminated.

Let’s now analyze how forward and futures prices are related to the spot price of the
underlying asset. We will first focus on forward contracts because they are much easier
to analyze than futures contracts. This is because there are no intermediate cash flows
in the case of such contracts, due to the absence of the marking to market mechanism.

Notation

We will use the following symbols to denote the corresponding variables:

• t ≡ the point in time at which we are standing, that is, today.

• T ≡ the point in time at which the forward contract expires.

• St ≡ current spot price of the asset underlying the forward contract.

• K ≡ delivery price as per the forward contract.

• Ft ≡ forward price of a contract initiated at time ‘t’ and expiring at time ‘T’.

• f ≡ current value of a long forward contract.

• r ≡ rate of interest for the period between ‘t’ and ‘T’.1

1
Note, this is not an annualized rate.

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Arbitrage

Arbitrage is the ability to make cost-less and risk-less profits. If we buy a Government
of India debt security, there is no default risk. However, we will nevertheless demand a
rate of return, which is the risk-less rate of return. If we we were to lend to a corporate
entity we would demand a higher rate of return, on account of the perceived credit
risk or default risk. The additional return demanded, over and above the risk-less rate,
is known as the Risk Premium. However, what if we are offered an opportunity that
requires no investment, entails no risk, but however offers a positive rate of return.
This would obviously be too good to be ignored. Such an opportunity is an arbitrage
opportunity. As an American would say, it is a free lunch. Here is an illustration.

Example 2.1

A share is trading at Rs 100 on the BSE and Rs 102.50 on the NSE. A trader picks
up one phone and says buy 1,000,000 shares, and simultaneously picks up another
phone, and says sell 1,000,000 shares. There is a profit opportunity of Rs 2,500,000
which is an arbitrage profit. In practice, this cannot be done as intra-day trades,
because offsetting has to be done on the same exchange. For trades that have to be
settled, both the exchanges have a T+2 settlement cycle, and hence a trader cannot
take possession of shares on one exchange, and then sell it on the other. However,
if at the outset, a trader has enough money in his bank account, and shares in his
demat account, then such arbitrage is possible. In practice, there will be practical
issues such as brokerage commissions, which can make such activities less profitable,
or even unattractive.

Forward Contracts on a Security that Provides No Income

A forward contract is also a commitment contract, like a futures contract. Consequently

it too imposes an obligation on both parties to a trade. The long is obliged to buy and the
short is obliged to sell. However, unlike futures contracts which are exchange traded,
forward contracts are not traded on organized exchanges. Consequently, a forward
contract is termed as an over-the-counter (OTC) contract.

42
 We focus first on assets that are not scheduled to make a payout during the life of
the contract. Obvious examples of such securities are stocks that pay no dividends, and
zero coupon bonds.

Cash and Carry Arbitrage

From the perspective of the party who has a short position in a forward contract, it
represents a commitment to make delivery. Consider the case of an investor with a short
position in the contract, and who has a unit of the underlying asset with him. He would
obviously have to fund the acquisition of the asset. It would entail an actual interest
cost if he were to borrow the required amount, and an opportunity cost if he were to
deploy his own funds. If the difference between the forward price, which is what he is
scheduled to receive at expiration, and the prevailing spot price at the outset, which
is the amount that he has financed, were to exceed the cost of carrying the asset until
delivery, then clearly there would exist an arbitrage opportunity. In the case of an asset
that pays no income, the only component of the carrying cost is the interest cost rSt,
where r is the risk-less rate of interest and St is the prevailing spot price at the time
of entering into the contract. Hence if the price differential were to exceed the interest
cost, or
Ft − St > rSt

then a person could exploit the situation by borrowing and buying the asset, and con-
currently taking a short position in a forward contract. Such a strategy, that is intended
to realize an arbitrage profit, is called cash and carry arbitrage. Hence, to rule out such
arbitrage, we require that

Ft − St ≤ rSt ⇒ Ft ≤ St (1 + r) (2.1)

Example 2.2

We will illustrate cash and carry arbitrage with the help of a suitable numerical
example.

Assume that Convergence Technologies is currently selling for Rs 50 per share,

and as per the forecast of investors, is not expected to pay any dividends for the

43
 next six months. We will assume that the price of a forward contract for one
share of the company to be delivered after six months is Rs 54. Let us take the
case of an arbitrageur who is in a position to borrow funds at the rate of 6% per
six monthly period. He can obviously borrow Rs 50 and acquire one share of the
company. Assume that at the time of the transaction, he simultaneously goes short
in a forward contract to deliver the share after six months for Rs 54. In other words
he locks in the sale price of the asset at the very outset. The rate of return on his
investment, for a six month horizon is:

(54 − 50)
= 0.08 ≡ 8%
50
whereas his funding cost is only 6%.

Thus, the arbitrage strategy that has been implemented is obviously a profitable
proposition. This is because the forward contract is overpriced, that is:

Ft > St(1 + r)

The rate of return for the arbitrageur in a cash and carry strategy is referred to as the
implied repo rate(IRR). Obviously, such an arbitrage strategy would be profitable only
if the implied repo rate were to exceed the borrowing rate faced by the arbitrageur.

The net result of such a strategy may be perceived as follows. By engaging in such a
transaction, the arbitrageur has ensured a payoff for himself of Rs 54 after six months,
in return for an initial investment of Rs 50. Thus, it is as if he has bought a zero coupon
debt security with a maturity value of Rs 54, by paying a price of Rs 50. Hence, a
combination of a long position in the underlying asset and a short position in a forward
contract is equivalent to a long position in a zero coupon security. Such a deep discount
instrument, which is artificially generated using other assets, is referred to as a synthetic
T-bill. Hence we can express the relationship as

Spot - Forward = Synthetic T-bill

In this expression, the negative sign in front of the forward contract denotes that the
arbitrageur has taken a short position in it. Thus, an investor who has taken natural
positions in any two of the three assets, can artificially create a position in the third.
One significant implication of the above equation is that although the spot and forward
44
positions are exposed to price risk when held in isolation, their long-short combination
leads to a risk-less position.

Reverse Cash and Carry Arbitrage

We have just seen that cash and carry arbitrage requires a short position in a forward
contract and arises if the contract were to be overpriced. That is:

Ft > St(1 + r)

However, what if the forward price, Ft were to be less than St (1 + r), or in other words
the contract were to be underpriced. It turns out that such a situation too represents an
arbitrage opportunity. However, to exploit the mispricing in this case, the arbitrageur
would have to take a long position in the contract. The strategy to be deployed under
such circumstances requires the investor to short sell the asset, invest the proceeds at
the risk-less rate of interest, and simultaneously take a long position in the forward
contract. This kind of an arbitrage strategy is called reverse cash and carry arbitrage,
and is feasible in those circumstances where the difference between the forward price
and the spot price is less than the carrying cost. In order to rule out such opportunities,
we obviously require that:
Ft ≥ St(1 + r) (2.2)

Example 2.3

Let’s illustrate reverse cash and carry arbitrage with the help of a numerical example.
We will assume once again that Convergence is selling for Rs 50 per share, and that
the company is not expected to pay any dividends for the next six months. We
will assume that the risk-less rate of interest continues to be 6% for this period.
However, the price of a forward contract for one share to be delivered after six
months will be assumed to be Rs 52.50.

Consider the following strategy which can be deployed by an arbitrageur under

such circumstances. He can short sell a share at Rs 50, invest the proceeds at a
rate of 6% for six months, and simultaneously take a long position to re-acquire the
share after six months at a price of Rs 52.50.

45
 One of the crucial assumptions that we have made in this illustration, is that the
arbitrageur can lend the proceeds from the short sale at the market rate of interest.
In practice, short selling entails the depositing of the proceeds with the broker. In
addition, the short seller has to put up additional collateral to protect the broker against
a subsequent rise in the price of the shares. The broker can obviously earn interest on
the amount deposited with him. Institutional investors can, in a competitive market,
demand that the broker share a part of the interest income with them. Such payments
are referred to as short interest rebates. However, even if the broker were to pay interest
to the client, the effective rate of return earned by the short seller will be lower than
the prevailing market rate.

The effective cost of borrowing for the short seller in our example is:
(52.50 − 50.00)
= 0.05 ≡ 5%
50.00
which is less than the lending rate of 6%. Thus the arbitrage strategy leads to a profit
for the investor. The reason why it is attractive is obviously because the contract is
underpriced. That is:
Ft < St(1 + r)

The effective borrowing cost incurred by an arbitrageur who employs such a strategy
is known as the implied reverse repo rate(IRRR). Hence, reverse cash and carry arbitrage
is profitable only if the implied reverse repo rate is less than the lending rate.

It must be emphasized that cash and carry arbitrage is profitable if the contract is
overpriced or equivalently the implied repo rate is greater than the borrowing rate. One
of these conditions implies the other. That is, an overpriced contract implies an IRR
that is greater than the borrowing rate and vice versa. Likewise, reverse cash and carry
arbitrage is feasible if the contract is underpriced or the implied reverse repo rate is less
than the lending rate. Once again, an underpriced contract implies an IRRR that is
less than the lending rate and vice versa.

Let us analyze the strategy from a related perspective. By engaging in such a

transaction, the investor has ensured the sale of what is akin to a zero coupon instrument
with a face value of Rs 52.50, for a price of Rs 50. Thus, a combination of a short position
in the stock and a long position in a forward contract is equivalent to a short position
in an artificial zero coupon instrument, which is what we have previously termed as a
synthetic T-bill. Hence we can express the relationship as:2
2
We are essentially multiplying both sides of the earlier relationship by minus one.

46
 -Spot + Forward = -Synthetic T-bill

Cash and carry arbitrage is feasible if the contract is overpriced, that is, Ft ≥
St (1+r), while reverse cash and carry arbitrage is feasible if the contract is underpriced,
that is, Ft ≤ St (1 + r). Thus, in order to rule out both forms of arbitrage, which is an
indication that the contract is fairly priced, we require that:

Ft = St(1 + r) (2.3)

In this example therefore, the no-arbitrage forward price should be Ft = 50×(1+0.06) =

Rs 53. This is known as the cost of carry relationship.

Short Selling

The ability to short sell the underlying asset is critical for the execution of a reverse
cash and carry arbitrage strategy. Let’s therefore take a closer look at the mechanics
of a short sale. Long positions in shares are taken by what we term as bulls. Such
investors acquire shares because they foresee an increase in their value over a period
of time. If their views were to turn out to be accurate, they can obviously liquidate
their long positions with a profit. Thus, the ability to take long positions constitutes a
speculative tool for those who are bullish about the market. The investment principle
being followed in such cases is therefore, ‘buy low and sell high’.

However, it is not necessary that all investors should have a bullish outlook at a
given point in time. There will always be those who expect the market to decline over
a period of time. Such investors are referred to as bears. These traders too require a
tool to facilitate speculation on their part. Short selling represents such a technique.

What is short selling and how is it accomplished? A short sale is carried out by
selling an asset that does not belong to the seller. Quite obviously, to do so he must
borrow it from another investor. In practice investors borrow from brokers. A broker
may have the shares in his personal inventory or else he may borrow it from a client
such as a financial institution. The securities which are borrowed in such fashion, have
obviously to be bought back and returned. The process of acquisition of shares to
close out an existing short position, is called ‘covering the short position’. Short sellers
undertake such positions in the belief that they can re-acquire the asset at a lower value
at the time of closing out the position. The principle is obviously ‘sell high and buy
47
low’. At times, during the period of the short sale, the asset may make a payout. In
the case of equity shares the company may declare a dividend, whereas in the case of
bonds the issuer may pay a coupon. The dividend or coupon in such cases will go the
current owner of the security. However, from the perspective of the party who has lent
the security to facilitate the short sale, he has merely lent it and not sold it. If he had
not parted with the asset he would have obviously received the payment. Hence, as
per the terms of the short sale agreement, the borrower of the securities is required to
compensate the lender for any lost income.

Similarly, there could be other corporate actions during the period of a short sale
such as a stock split. If so, the short seller has to make the necessary adjustment while
returning the shares. For instance, if there were to be a 5:1 split, an investor who has
borrowed one share prior to the split, is responsible for returning five shares after the
split.

When a trader borrows a share from a broker and sells it, he has an obligation
to buy it back eventually. From the standpoint of the broker there is always a risk
that the security which the short seller thinks will depreciate in value, actually ends up
appreciating. Consequently the broker needs to guard against the possibility of default.
Thus, the broker in practice will retain the sale proceeds with him. Further, to protect
himself against rising prices, he will require the party who is selling short to deposit
additional collateral. Lenders of securities will receive a stock lending fee. After all, if
cash should not be kept idle, why should securities.

Forward Price versus Delivery Price

Let’s first understand the difference between the forward price and the delivery price.
The delivery price is the price that is specified in the forward contract. That is, it is
the price at which the short is obliged to make delivery or equivalently it is the price at
which the long is obliged to take delivery.

The forward price, at any point of time, is the applicable delivery price for a contract
that is being negotiated at that particular instant. If a contract were to be sealed, based
on the bilateral negotiations, the prevailing forward price would become its delivery
price. However, a contract that were to be negotiated an instant later is unlikely to
have the same forward price. In other words, the forward price will keep changing as
new trades are negotiated.

48
 Let’s view the issue as follows. If a trader were to make a statement that she had
taken a forward position at a prior point in time, the natural response would be “what
was the delivery price?” and not “what was the forward price then?”, although both
would mean the same thing. However if we were to be confronted with an offer to get
into a forward position, the question to ask would be “what is the forward price?”. If
the contract were to be sealed, the current forward price would become the delivery
price of the contract, which would remain invariant for the life of the contract.

The Value of a Forward Contract

The value of a forward contract when it is first entered into is zero.3 Later on, it may
have a positive or a negative value.

In the earlier example, the current equilibrium forward price, for a contract on
Convergence, was Rs 53, which by definition, was equal to the delivery price of a contract
being negotiated at that point in time. Let us consider another forward contract that
was entered into a while earlier, with a delivery price of Rs 50. At that time, the forward
price would have been equal to Rs 50. Today, say a week later, the delivery price as
per the contract is still Rs 50, but the forward price is Rs 53. So the question is, what
value will the old contract have today?

Consider the holder of a long forward contract with a delivery price of Rs 50. He
will require Rs 50 after six months to pay and take delivery. So all he needs today, is the
present value of Rs 50, which if invested at the prevailing rate of 6%, will be adequate
for taking delivery after six months.
50
The present value of Rs 50 = = 47.1698. Hence, if this person has Rs 47.1698
1.06
plus one long forward contract, then he will be entitled to one share of Convergence
after six months. Now, consider another individual who pays Rs 50 now and buys one
share of Convergence in the spot market. At the end of six months, he too will be in
possession of one share of the company. Thus, the portfolios held by both these persons
will be worth the same at the end of six months. If the future values of these portfolios
are the same, then they must have identical present values.

Let f be the value of the forward contract. Therefore

f + 47.1698 = 50 ⇒ f = 2.8302.
3
Neither the long nor the short, has to make a payment to the counterparty.

49
Hence, the value of a forward contract with a delivery price of Rs 50 is Rs 2.8302. In
symbolic terms
K
f = St −
(1 + r)
From the no-arbitrage condition we know that
Ft
St =
(1 + r)

Therefore
Ft K (Ft − K)
f= − = (2.4)
(1 + r) (1 + r) (1 + r)
Thus the value of a long forward contract is the present value of the difference between
the forward price and the delivery price. Since a forward contract is a zero sum game,
the value of a short forward contract, is the present value of the difference between the
delivery price and the forward price.

This can be understood as follows. An investor has the option of getting into a
forward contract at the prevailing forward price of Rs 53. Thus, if he is offered a
contract with a lower delivery price, he will obviously be willing to pay for it. In this
case he will be willing to pay Rs 2.8302. If the value of the pre-existing contract is
negative, say - Rs 2.75, then the current holder will have to pay to get rid of it.

Now, you are aware that forward contracts are customized contracts that are nego-
tiated individually between the buyer and the seller. So you may be wondering how the
holder of a long forward contract can possibly realize the value that we have calculated
above? In order to realize the value of the above contract, all the holder has to do, is to
enter into a new contract that offsets the original. We will illustrate this with the help
of an example.

Example 2.4

Consider a person who is holding a long forward contract on ION, with a delivery
price of Rs 50. In order to get out of his position, he will have to go short in a fresh
contract with a current delivery price of say Rs 55. At expiration therefore, he can
buy the asset under the first contract at Rs 50 and sell it under the second at Rs 55.
So he has a guaranteed payoff of Rs 5 waiting for him at expiration. If we assume

50
 that the risk-less rate is 8%, then the value of his original contract is the present
value of this future payoff. That is:
5
Value = = 4.6296
1.08

Value of a Futures Contract

Having understood how to determine the value of a forward contract, let us now turn
our attention to futures contracts. At the outset, neither the long nor the short has to
pay to get into a position in either a forward or a futures contract. However, as the
futures price changes subsequently, an open futures position will acquire value. There
is however a difference between forwards and futures in terms of how this value is dealt
with. In the case of futures contracts, due to the marking to market mechanism, the
profit/loss is calculated at the end of every day and credited/debited to the margin
account. The position is then re-initialized at the settlement price that is used to mark
to market at the end of that particular day. This process of marking to market is
nothing but a settlement of built up value. Thus, once the profit/loss is adjusted, the
value of the futures contract will once again revert back to zero. Therefore, the only time
futures contracts accumulate value, is in the period between two successive settlement
price calculations. Once the settlement of built up value occurs at the end of the day,
the value of both long and short positions will go back to zero.

Forward Contracts on Assets that Provide a Known Cash

Income

Let us now go on to consider the case of forward contracts on assets that provide a
perfectly predictable cash income. Examples include stocks which pay known dividends
and coupon paying bonds. If an investor were to get a cash inflow from the asset that
he is holding, then he would obviously have a reduced carrying cost. The carrying cost
on account of interest, as we have seen before, is rSt. Let us denote the future value
of the income from the asset, as calculated at the time of expiration of the forward
contract, by I. Why do we need to calculate the future value of the income? The
carrying cost is computed at the point of expiration of the futures contract. In order

51
to be consistent with the principles of time value of money, the value of the income too
should be computed at the same point in time. Hence, if the income were to be received
prior to the time that the contract matures, it has to be compounded for the remaining
period using the risk-less rate of interest. Consequently, in order to rule out cash and
carry arbitrage we require that

Ft − St ≤ rSt − I ⇒ Ft ≤ St (1 + r) − I (2.5)

Now let’s consider a reverse cash and carry arbitrage strategy. This strategy entails a
short sale, and as we have mentioned earlier, the short seller is responsible for compen-
sating the lender of the asset for any lost income. Consequently, the effective income
obtained by a short seller by investing the proceeds from the sale will be reduced by
the amount of payouts from the asset. Hence, reverse cash and carry arbitrage will be
profitable only if
Ft − St < rSt − I

Thus to rule out reverse cash and carry arbitrage we require that

Ft − St ≥ rSt − I ⇒ Ft ≥ St (1 + r) − I (2.6)

Hence, to preclude both forms of arbitrage it must be the case that

Ft = St (1 + r) − I (2.7)

Let’s now illustrate the two arbitrage strategies in the case of forward contracts on
a share that pays a known dividend. We will continue with the Convergence example
but will now assume that the stock pays a dividend of Rs 2.50 after three months and
another Rs 2.50 after six months. The second payment is assumed to be made an instant
prior to delivery under the forward contract. We also assume that an arbitrageur can
borrow or lend at the rate of 6% per semiannual period. Let the forward price be Rs
48.50.

Cash and Carry Arbitrage

Consider the following strategy. Buy one share of Convergence, by borrowing the Rs
50 required to finance the purchase. Simultaneously enter into a forward contract to
sell one share after six months at Rs 48.50. During this period of six months, you will
get a dividend of Rs 2.50 after three months, followed by another dividend of Rs 2.50

52
three months later. The first dividend can be invested until the expiry of the forward
contract at 6% per six months. So at the end of six months, you will get Rs 48.50 when
you deliver the share, plus interest and principal on account of the first dividend that
you have invested, plus the second dividend. So the total final cash inflow is
1
 
48.50 + 2.50 1 + × 0.06 + 2.50 = 53.575.
2
The rate of return is:
(53.575 − 50)
≡ 7.15%
50
for six months. But the borrowing rate is only 6% per six-monthly period. Hence, it is
obvious that there is an arbitrage opportunity. So the forward price of Rs 48.50 does
not represent equilibrium. The IRR is greater than the borrowing rate, which obviously
means that the contract is overpriced.

Let’s now consider another case where the forward price is Rs 46.50. The above
strategy, as you can verify, will not yield arbitrage profits. But it turns out that you
can make arbitrage profits by reversing the strategy.

Reverse Cash and Carry Arbitrage

This strategy can be executed as follows. Short sell one share of Convergence at Rs 50
and go long in a forward contract to enable you to procure one share after six months.
Three months later, you would require Rs 2.50 to compensate the person who lent you
the share because he would have received a dividend equal to this amount had he not
parted with the share. This amount can be borrowed at 6% per half-yearly period. Once
again, by the same logic, at the end of another three months you would be required to
pay Rs 2.50, which once again would have to be borrowed.

Thus your total outflow at the end of six months is

1
 
46.50 + 2.50 1 + × 0.06 + 2.50 = 51.575
2
By engaging in the above strategy, you have effectively taken a loan of Rs 50, and paid
back Rs 51.575 six months later. The interest rate on the borrowing is

(51.575 − 50)
= 3.15%
50
However, the Rs 50 that you receive when you short sell the stock, can be lent at 6%
for six months. Thus, there clearly exists an arbitrage opportunity. The IRRR is less
53
than the lending rate, or, in other words, the contract is underpriced. Hence a price of
Rs 46.50 does not represent equilibrium either. Thus 48.50 is too high whereas 46.50 is
too low. The no-arbitrage price obviously lies somewhere in between.

Once again, to eliminate arbitrage profits, the IRR must equal the IRRR, which
must equal the borrowing and lending rates. Let Ft be the equilibrium forward price.
Then:
(Ft + 5.075 − 50)
= 0.06 ⇒ Ft = 47.925
50
The amount of Rs 5.075 is the future value at the end of the six monthly period, of the
payouts from the asset during the period, which we have denoted by I. Therefore, in
symbolic terms
(Ft + I − St )
= r ⇒ Ft = St (1 + r) − I
St

Forward Contracts on Commodities

Thus far we have considered assets that provide no income like non dividend paying
stocks and zero coupon bonds, and assets which pay a known cash income like coupon
paying bonds.

Let’s now consider the case of commodities. Commodities typically do not earn any
income. On the contrary, it costs money to store them and to insure them against un-
foreseeable events. It turns out that we must make a distinction between commodities
that are held mainly as investments by most investors (typical examples are precious
metals) and those that are held for consumption purposes (like agricultural commodi-
ties).

Restrictions on Short Sales

For the pricing relationships that we have developed thus far to hold, both cash and carry
as well as reverse cash and carry arbitrage should be freely possible. Let’s recapitulate
these strategies. The cash and carry strategy, requires that the arbitrageur buy the asset
and take a short position in the forward contract. This per se, should pose no problems.
But in the reverse cash and carry arbitrage strategy, the arbitrageur is required to short
sell the asset and go long in a forward contract. The problem is that there are certain
assets, which are held by people for reasons other than pure investment. People who
choose to hold these assets get some special benefits from them and therefore may not
54
be willing to lend them for short sales. In such cases, reverse cash and carry arbitrage
will be infeasible. We will first make a distinction between pure and convenience assets
and then will go on to look at detailed examples, which will hopefully help clarify these
and other related issues.

Pure Versus Convenience Assets

What is the definition of a short sale? It is a transaction wherein you hand over an
asset to a person, who immediately sells it and returns it intact to you at a future date.
Any income that you would have received in the intervening period is given to you by
the borrower of the asset, be it dividends or coupon payments. So, if you do not really
require the asset during the period of the short sale, you are not foregoing anything.

The above argument is true if the owner of the asset is holding it for an investment
purpose, that is, to earn capital gains and other income due to him. Such assets are
called pure assets or investment assets. Financial assets such as stocks and bonds are
examples of pure assets.

On the other hand, certain assets like wheat or rice are often held for reasons other
than potential returns. Such assets are called convenience or consumption assets. The
owners of such assets may not permit them to be sold short. This can best be clarified
with the help of an example.

Example 2.5

Let us consider the case of wheat. As everyone is aware, prices usually rise before a
harvest season and fall thereafter. A person who hoards wheat before the harvest,
not only has to incur storage costs but also faces the specter of a capital loss. Thus
from an investment angle, it makes little sense for a person to hoard wheat during
the harvest period. But a wheat mill owner may choose to hold the commodity
for other reasons. For instance, he may want to avoid closing the mill during an
unanticipated temporary shortage, which may be due to a natural calamity or a
rainfall failure. The value of such potential needs is called the convenience value.

The holder of a convenience asset, will possibly give it up for a short sale only if he
is compensated for the convenience value. Thus, you may feel that the convenience

55
 value is similar in principle to a dividend. But there are differences. First, how do
you quantify a convenience value? Second, the perception of value will differ from
holder to holder, whereas all shareholders in a company receive the same dividend
per share. That is why, we do not have markets for short selling convenience assets.

Investment Assets

We will illustrate our arguments for the pricing of such assets using gold, which is
primarily held for investment purposes. To keep matters simple, let us initially assume
that storage costs are zero. If so, gold is similar to an asset that pays no income. The
cash and carry and reverse cash and carry arguments, can then be used to show that

Ft = St(1 + r)

A cost is nothing but a negative income. For an asset which pays a known income,
we have shown that
Ft = St (1 + r) − I
where I is the future value of payouts from the asset. Let us denote the future value of
storage costs by Z. Therefore

Ft = St (1 + r) − (−Z) = St (1 + r) + Z (2.8)

We will illustrate the no-arbitrage pricing condition for gold, using a suitable example.

Example 2.6

Let the spot price of gold be $800 per ounce and the rate of interest be 7.50% per
half-yearly period. We will assume that storage costs are $10 per ounce per six
monthly period, payable at the end of the period and that forward contracts are
available for delivery six months into the future. If so:

Ft = 800 × (1.075) + 10 = 870

Now let us consider mispriced forward contracts and the strategies for exploiting
them.

56
 Case A

Consider the case where Ft = $880. The contract is clearly overpriced. So to

exploit this opportunity, a person can engage in cash and carry arbitrage. Consider
the following strategy.

Borrow $800 and buy one ounce of gold. Simultaneously, go short in a forward
contract to sell the gold after six months at $880. Six months later, when the gold
is delivered, you will receive $880 and will have to pay $10 by way of storage costs.
Thus your net inflow = $870. The rate of return is:

(870 − 800)
= 0.0875 ≡ 8.75%
800
which is greater than the borrowing rate of 7.50%. So clearly, Ft cannot be greater
than St (1 + r) + Z.

Case B

Let Ft = $860. The contract is underpriced. Conventional reverse cash and carry
arbitrage arguments will entail the use of the following strategy.

Short sell the gold at $800 per ounce and simultaneously go long in a forward
contract to buy at $860. The effective borrowing rate is:
860 − 800
= 0.075 ≡ 7.50%
800
which is the same as the lending rate. Thus, although the contract is obviously
underpriced, a conventional reverse cash and carry strategy does not yield a profit.
For such a strategy to yield profits to the arbitrageur, the lender of the gold would
have to pass on at least a part of the storage cost saved by him, which is $10 in this
case. Let us assume that the lender does pass on $7.50 to the arbitrageur. If so,
the arbitrageur’s net outflow will be $852.50, which means that the implied reverse
repo rate is 6.5625%, which is less than the lending rate of 7.50%.

In practice however, it is not usually possible to sell short in such a way that, the
person lending the asset actually passes on the storage costs saved to the short seller.
57
So does it mean that Ft can be less than St(1 + r) + Z, for an investment asset like gold?

The answer is no. If Ft were to be less than St (1 + r) + Z, then the mispricing can
be exploited by a person who already owns gold. Consider the following strategy. A
person who owns gold, but does not require it for six months, can sell it in the spot
market and invest the proceeds. He can also go long in a forward contract to re-acquire
the gold at the end of six months.

When he sells the gold, he will receive $800. This will yield 800 × (1.075) = $860 at
the end of six months. He will also have an additional $10 with him, which represents
the storage costs saved. After paying $860 to re-acquire the asset, he will have $10 with
him, which represents an arbitrage profit.

The arguments that we have used above, represent a strategy known as quasi-
arbitrage. The person who engages in such a strategy has not engaged in arbitrage
in the conventional sense. Rather, he has liquidated his position in the asset and has
employed a strategy which effectively ensures that he gets the asset back at the end of
six months. In other words, it is as if he has effectively not parted with the asset. In
the parlance of derivatives, we say that he has replaced an actual spot position with a
synthetic spot position, or to put it differently he has sold an asset without really selling
it.4

Thus quasi-arbitrage will help ensure that Ft cannot be less than

St(1 + r) + Z

Hence, to rule out both cash and carry arbitrage, as well as reverse cash and carry
quasi-arbitrage, we require that

Ft = St (1 + r) + Z

Consumption Assets

Let us now consider the case of wheat. If

Ft > St (1 + r) + Z

then the resultant arbitrage opportunity can be exploited using a cash and carry strat-
egy. But if
Ft < St (1 + r) + Z
4
We will have more to say about quasi-arbitrage and synthetic positions, a little later.

58
then it may not be possible to make arbitrage profits. Conventional reverse cash and
carry arbitrage may not be possible because short sales may not be feasible. Reverse
cash and carry quasi arbitrage may also not be possible because the person who is
holding the asset may be getting a convenience value.

Consequently, it may be the case that

Ft < St (1 + r) + Z

and that no one is able to exploit any opportunities for making arbitrage profits.

Assets such as wheat are usually consumption assets. In the case of such assets, all
that we can say by way of a no-arbitrage pricing relationship is that

Ft ≤ St (1 + r) + Z (2.9)

The marginal convenience value Y is defined to be that value which satisfies the
following equation, for convenience assets

Ft = St (1 + r) + Z − Y (2.10)

The marginal convenience value is the lowest of the convenience values, as perceived by
different market participants.5

Net Carry

Consider the case of an asset that pays a known income. The no-arbitrage pricing
relationship for such assets, states that

Ft = St (1 + r) − I

This implies that

Ft I (Ft − St ) I
=1+r− ⇒ =r−
St St St St
The net carry is defined as interest minus the future value of payouts, divided by the
spot price of the asset. Therefore
(rSt − I) I
net carry = =r− . (2.11)
St St
5
Remember, as we said earlier, it is not necessary that everyone should have an identical convenience
value.

59
Hence
(Ft − St )
net carry = ⇒ Ft = St + (net carry)St (2.12)
St
If the net carry is positive, then the forward price will exceed the spot price, else it
will be less than the spot price. In the case of physical commodities which are held for
investment purposes, I = -Z, where Z represents the cost of storage. Therefore
−Z Z
net carry = r − =r+ (2.13)
St St
which is positive. Thus, the forward price for such commodities will be greater than the
spot price.

However, in the case of consumption assets, where a convenience value is involved

Ft = St + (net carry)St − Y (2.14)

where Y is the convenience value. In this case, the relationship between the forward
price and the spot price, would depend on the relative magnitudes of the net carry and
the convenience value.

If Y = 0, we say that the market is at full carry, whereas if the convenience value is
positive, we say that the market is not at full carry.

Backwardation and Contango

If the futures price exceeds the spot price or the price of the nearby futures contract is
less than that of the more distant contract, then we say that there is a contango market.
Whereas if the futures price is less than the spot price or the price of the nearby futures
contract is more than that of the distant contract, then we say that the market is in
backwardation. Consider the following data.

Example 2.7

The data given below represents hypothetical prices for corn. Case A illustrates a
backwardation market whereas Case B is an illustration of a contango market. A
particular commodity, need not continuously display the characteristics of either a
backwardation or a contango market. That is, the market may switch from one
mode to another.

60
 Case A: Backwardation Market

Table 2.1
Backwardation Market
Contract Price
Spot 6.95
March Futures 6.82
May Futures 6.65
July Futures 6.30
September Futures 6.15

Case B: Contango Market

Table 2.2
Contango Market
Contract Price
Spot 6.75
March Futures 6.85
May Futures 6.95
July Futures 7.10
September Futures 7.25

What could be the possible reasons for a backwardation market in corn? Quite
obviously, the market is not at full carry, implying that there is a convenience yield. In
other words, reverse cash and carry arbitrage is not feasible.

The most likely reason for such a scenario, is that corn is in short supply. If so,
people will not be willing to lend for the purpose of a short sale, or else indulge in
quasi-arbitrage themselves. Under such circumstances, they may need it for fulfilling
sale contracts entered into in advance or else for their own use. In practice it has been
observed that markets tend to be in backwardation when spot prices are rising. And
rising spot prices are an obvious indication of impending shortages.

For financial assets, the net carry can either be positive or negative, depending on

61
the relationship between the financing cost, rS, and the future value of the payouts from
the asset, I. If the financing cost were to exceed the value of the payouts, the net carry
will be positive, and we will have a contango market. Otherwise, the net carry will be
negative, which will reveal itself as a market in backwardation.

In the case of physical commodities, if the market is at full carry, then we will
always have a contango market. However, if the market is not at full carry, then we
may either have a backwardation or a contango market. If the net carry is greater
than the convenience value, there will be a contango market, else the market will be in
backwardation.

Synthetic Securities

Let us take another look at the cash and carry arbitrage argument. According to this
strategy, if we buy the good in the spot market and simultaneously go short in a forward
contract, it is as if we have gone long in a T-bill. Therefore

Spot - Forward6 = Synthetic T-bill.

The terms can be repositioned to yield the following results:

• Spot - T-bill = Synthetic Forward.

• Forward + T-bill = Synthetic Spot.

Thus, if we have any two of the assets, we can artificially create the third. It is very
important to understand the principles behind the creation of synthetic positions, before
we go on to take a detailed look at quasi-arbitrage.

Forward Prices Versus Futures Prices

In all the cases where we have derived the pricing relationships based on the no-arbitrage
arguments, we have considered forward contracts and not futures contracts. This was
because as we said at the outset, forward contracts are easier to analyze since they entail
only a single cash flow at the end, whereas futures contracts are marked to market daily,
and consequently involve intermediate cash flows.
6
The minus sign indicates a short position

62
 It can be shown that when the risk-less rate of interest is a constant, and is the same
for all maturities, then the forward price for a contract on a given asset for a specified
delivery date, is the same as the futures price for a contract on the same asset, for the
same delivery date. Therefore, under such conditions, the relationships that we have
derived for the prices of forward contracts, are equally valid for the prices of futures
contracts.

Risks Inherent in Arbitrage

Thus far, we have presented cash and carry arbitrage and reverse cash and carry ar-
bitrage strategies, as positions designed to earn cost-less risk-less profits. In practice,
however, an arbitrageur who seeks to implement such strategies will have to confront a
variety of risks.

Cash and carry arbitrage requires the investor to borrow at the risk-less rate of
interest in order to acquire the underlying asset. In practice, such investors may be
unable to borrow at an interest rate that remains constant for the duration for which
the position is in place, and hence they may have to borrow for shorter periods and roll
over the loan. Therefore, the risk faced by such arbitrageurs is that interest rates may
rise after they have implemented the strategy. Such risk is referred to as financing risk.

Second, in the case of assets which are scheduled to make payouts during the life
of the contract, the potential to make arbitrage profits is critically linked to the arbi-
trageur’s ability to forecast the payouts. If the asset does not make payouts as fore-
casted, then the profits that are expected at the outset may not materialize. Such risk
is referred to as payout risk or dividend risk.

It should be obvious to the reader that such risks are factors in the case of reverse
cash and carry arbitrage strategies as well.

Stochastic Interest Rates

In real life, interest rates are stochastic and hence forward prices need not equal futures
prices. Let us consider a situation where interest rates and futures prices are positively
correlated. If the futures price rises, the interest rate will also be high. When the price
rises, the long will gain and in this case, will be able to invest his gains at a higher rate

63
of interest. Correspondingly, in such a scenario, the short will be financing his losses7
at a higher rate. Conversely, if the futures price falls, the interest rate will be low. This
is a situation where the long will lose and the short will gain. Thus the long will be
financing his losses at a lower rate, while the short will be investing his gains at a lower
rate.

An investor with a long forward position, will however not be affected by interest
rate movements in the interim, for his position will not be marked to market. Hence,
an investor with a long futures position is clearly better off under such circumstances.
Extending the argument along similar lines, a person with a short futures position is
worse off than a person who has gone short in a forward contract. Since a long futures
position is more attractive than a long forward position, the person going long in the
futures contract should pay more for this advantage. In other words, the investor going
short in the futures contract should receive more for this disadvantage. Hence, the
futures price will exceed the forward price, when futures prices and interest rates are
positively correlated.

Similar logical reasoning can be used to demonstrate that if interest rates and futures
prices are negatively correlated, then the futures price will be less than the forward
price.8

Quasi-Arbitrage

The kind of arbitrage that we have discussed thus far, in connection with the cash and
carry and reverse cash and carry strategies, is called pure arbitrage. Arbitrageurs, who
engage in pure arbitrage, are forever on the lookout for mispriced securities and will
exploit the profit opportunities until equilibrium is restored.

Quasi-arbitrage9 is engaged in by investors who are not arbitrageurs in the conven-

tional sense. The term refers to the use of cash and carry and reverse cash and carry
techniques by investors, as alternative means of establishing a desired position in the
market. For, as we have discussed in the section on synthetic securities, if we have two
out of three securities, we can artificially take a position in the third.

We will illustrate this concept with the help of an example.

7
It may either be in the form of an actual borrowing or as an opportunity cost.
8
Readers should reason this out and convince themselves.
9
For an elaborate discussion of quasi-arbitrage see Siegel and Siegel(1990).

64
Example 2.8

Ralph Keating, is planning to make an investment in a risk-less security for six

months. One course of action that is available is to directly invest in a risk-less
asset such as a T-bill. The ask price for a six month T-bill with a face value of
$100,000, is $98,875. The brokerage fee for an investment in bills with a face value
of $100 is 12.5 cents. So for a bill with a face value of $100,000 Ralph will have to
pay a commission of $125. The total cost of acquisition is therefore $99,000 and the
corresponding rate of return is:
100, 000 − 99, 000
≡ 1.0101%
99, 000

Now let us consider an arbitrage strategy. Assume that IBM shares are available
at a price of $90.25 per share. Futures contracts on the stock, maturing after six
months are available for $91.50. A pure arbitrageur can borrow at the rate of 1.25%
for six months. The brokerage fees payable in the market are as follows. For every
share that is bought or sold in the stock market, a commission of 12.50 cents is
payable. For a transaction in futures contracts, a fee of 5 cents is payable per share.
Finally, we will assume that while borrowing funds, the pure arbitrageur has to pay
12.50 cents for every share. Thus, the rate of return for a pure arbitrageur if he
engages in a cash and carry strategy is
91.50 − (90.25 + 0.125 + 0.05 + 0.125)
≡ 1.0491%
(90.25 + 0.125 + 0.05 + 0.125)
which is less than the borrowing rate of 1.25% . So clearly a pure arbitrageur cannot
profitably engage in cash and carry arbitrage.

But in Ralph’s case, instead of investing in T-bills, he can go long in the spot
market and take a short position in the futures market, thereby creating an invest-
ment in a synthetic T-bill. His transaction costs are 12.5 cents for every share that
he buys and five cents for every futures contract that he goes short in. Notice, that
unlike the pure arbitrageur, he does not have to borrow. Consequently, his rate of
return is
91.50 − (90.25 + 0.175)
≡ 1.1888%
(90.25 + 0.175)
Thus, his rate of return if he follows this strategy, will be higher than what he
would get if he were to invest in T-bills. Hence, a person like Ralph, who is looking

65
 for a risk-free investment, would rather engage in a cash and carry strategy to buy
synthetic T-bills. This is what we mean by quasi-arbitrage.

Notice certain key features inherent in the above argument. First, although pure
arbitrage is not feasible, quasi-arbitrage is profitable. Second, a pure arbitrageur will
compare the implied repo rate with the borrowing rate, whereas a person like Ralph, who
is contemplating a quasi-arbitrage strategy, will compare the return from this strategy
with his alternative lending rate.

Finally, there is one major issue that you must understand. A pure arbitrageur will
exploit a perceived arbitrage opportunity till it vanishes.10 A quasi-arbitrageur, is how-
ever, constrained by the amount of funds at his or her disposal. In the above example, if
we assume that Ralph has $1,000,000 with him, then his ability to buy synthetic T-bills
will be restricted to this amount. If he wants to invest further in the cash and carry
strategy, then he would have to borrow money, which would be tantamount to pure arbi-
trage and therefore will not be profitable. A consequence of this is that quasi-arbitrage
opportunities are likely to persist longer than pure arbitrage opportunities, since each
potential quasi-arbitrageur, faces his or her own funds constraint and hence, may not
be able to exploit the opportunities for profit till they are completely eliminated.

10
Remember that we have assumed that he can borrow or lend an unlimited amount of money.

66
 True/False Questions

State whether the following statements are True or False.

1. In order to preclude cash and carry arbitrage, the implied repo rate should be less
than the borrowing rate.

2. The value of a short position in a forward contract, is the present value of the
difference between the delivery price and the forward price.

3. If the marginal convenience yield is positive, we say that the market is at full
carry.

4. If the futures price exceeds the spot price, then the market is said to be in back-
wardation.

5. A long position in the spot plus a long forward contract is equivalent to a synthetic
T-bill.

6. If the risk-less rate of interest is a constant and is the same for all maturities, then
the forward price for a contract on an asset with a given delivery date, will be the
same as the futures price for a contract on the same asset, for the same delivery
date.

7. If futures prices and interest rates are positively correlated, then the forward price
will exceed the futures price.

8. Quasi-arbitrage opportunities usually persist for a longer time than pure arbitrage
opportunities.

9. Interest rate risk and dividend risk have implications for both cash and carry as
well as reverse cash and carry arbitrage.

10. In the absence of arbitrage opportunities, futures contracts on financial assets

must always be in contango.

11. In the absence of arbitrage opportunities, futures contracts on physical assets that
are held for investment purposes must always be in contango.

12. Restrictions on short sales have implications for both cash and carry as well as
reverse cash and carry arbitrage.

67
13. For a financial asset, the net carry may be positive or negative.

14. The marginal convenience value is the highest of the convenience values as per-
ceived by market participants.

15. The maximum loss from a short sale is infinite in principle.

16. The forward price may be equal to the delivery price of a contract.

17. The collateral that is deposited by a short seller in practice, must be higher than
the sale proceeds.

18. The magnitude of the value of a long forward contract will be equal to the mag-
nitude of the value of a similar short forward contract.

19. If an asset cannot be sold short it is not an investment asset.

20. Consumption assets will always have a storage cost of zero.

21. Spot positions and risk-less positions can be created synthetically but forward
contracts cannot.

22. Quasi-arbitrage may be possible when pure arbitrage is not.

23. If loans and investments have to be rolled over, a cash and carry arbitrageur will
benefit from declining interest rates.

24. If dividends are higher than forecasted, a reverse cash and carry arbitrage strategy
may end up with a loss ex-post.

25. If the futures price is greater than the spot price, a near month contract must
have a lower price than a far month contract.

68
 Match The Phrases

Panel A

1. Price mentioned in a forward contract

2. An arbitrage strategy that requires the freedom to sell short

3. The effective borrowing cost incurred in a reverse cash and carry arbitrage
strategy

4. The investment philosophy of a short-seller

5. An asset which is held for reasons other than investment

6. The convenience value of an investment asset is equal to a value of

7. The creation of synthetic securities at a profit is termed as

8. If the net carry of a financial asset is positive the market will be in

9. If the interest cost is less than the future value of payouts, a financial asset
will be in

10. The rate of return from a cash and carry arbitrage strategy is termed as

11. Reverse cash and carry quasi-arbitrage is undertaken for

12. The risk that forecasted dividends may be different from actual dividends is
termed as

13. If the implied repo rate is higher than the borrowing rate, then this strategy
is profitable

14. The present value of the difference between the forward price and delivery
price, for a long forward position is known as

15. Every time a futures contract is marked to market, its value reverts back to

16. The equivalent of income for a physical asset held for investment purposes is

17. Rising spot prices are usually an indication of an impending

69
 18. A combination of a long spot position and a short forward position is

19. Long futures positions benefit from interest rates that are

20. The risk that interest rates may increase or decline subsequently is termed as

Panel B

Zero

Payout risk

Shortage

Value

Cash and carry arbitrage

Quasi-arbitrage

Sell high and buy low

Delivery price

Implied reverse repo rate

Positively correlated with futures prices

Storage costs

Risk-less

Zero

Financing risk

Contango

Consumption or convenience asset

Physical investment assets

Reverse cash and carry arbitrage

Implied repo rate

70
Backwardation

71
 Multiple Choice Questions

1. Which of these statements is true:

(a) A long spot position in isolation is risky

(b) A short forward position in isolation is risky
(c) A long spot position combined with a short forward position is risk-less
(d) All of the above

2. If a forward contract is fairly priced, which of these statements is false:

(a) It will be at full carry if the underlying is a financial asset

(b) It will be at full carry if the underlying asset is a physical asset held for investment
(c) It may be at less than full carry if the underlying asset is held for consumption
purposes.
(d) None of the above

3. If cash and carry arbitrage is possible, which of these statements is false:

(a) The contract must be overpriced

(b) The IRR must be greater than the borrowing rate
(c) The market must be in contango
(d) None of the above

4. In which of these strategies is there financing risk and payout risk:

(a) Cash and carry arbitrage

(b) Reverse cash and carry arbitrage
(c) Both (a) and (b)
(d) Neither (a) nor (b)

72
5. If futures contracts on a commodity are in backwardation:

(a) There must be a convenience value

(b) The asset must be held for consumption purposes
(c) The futures price will be less than the spot price
(d) All of the above

6. The convenience value for a physical asset is greater than zero. Which of these statements
is true:

(a) It must be in contango

(b) It may be in contango
(c) It must be in backwardation
(d) None of the above

7. Assume the cost of carry relationship holds and that the underlying asset is a financial
asset. Which of these statements is true:

(a) If the market is in contango then the asset must be non-dividend paying
(b) If the market is in backwardation then the asset must be dividend paying
(c) If the market is in contango then the interest rate must be lower than the dividend
yield
(d) None of the above

8. A trader finds that reverse cash and carry arbitrage is possible using futures contracts on
an asset. Which of these statements may be true:

(a) Short-selling may be freely permissible.

(b) He may be one of those who are willing to replace a natural spot position with a
synthetic spot position.
(c) Ex-post he may end up with a grade that is different than what was short sold at
the outset.
(d) All of the above

73
 9. An asset is priced at Rs 500 per unit. The risk-less borrowing and lending rates are both
8% per annum. The forward price for a one-year contract is Rs 535 per unit. The market
is in equilibrium in the sense that no arbitrage activity is profitable. Which of these
statements may be true:

(a) It is an investment asset with an income that is less than or equal to Rs 5 per annum.
(b) It is a consumption asset with a positive storage cost and a positive convenience
value
(c) It is a consumption asset with a zero storage cost and a positive convenience value
(d) All of the above

10. The spot price is Rs 100. The interest rate is 6% per period. The payout is Rs 2.50 at
the middle of the period. The market uses simple interest for pricing. Which of these
statements is true:

(a) The no-arbitrage futures price is Rs 103.425

(b) The no-arbitrage futures price is Rs 103.350
(c) The no-arbitrage futures price is Rs 103.500
(d) None of the above

11. The spot price is Rs 100. The interest rate is 6% per period. The payout is Rs 6 in
the middle of the period. The market uses simple interest for pricing. Which of thes
statements is true:

(a) The market is in contango

(b) The market is in backwardation
(c) The market may be in backwardation
(d) The market may be in contango

74
12. Which of these statements is true, if the marginal convenience value is positive:

(a) The market will be in backwardation

(b) The market will be in contango
(c) The asset may be pure
(d) None of the above

13. Which of these statements is true:

(a) Short-selling as a strategy is adopted by bearish investors

(b) Short-sellers believe in the maxim of sell high and buy low
(c) If there are payouts when the asset is on loan the short-seller has to compensate the
lender of the security
(d) All of the above

14. Which of these statements is true:

(a) Quasi-arbitrage opportunities may linger longer than pure arbitrage opportunities
(b) Quasi-arbitrage may be possible in a situation where pure arbitrage is not
(c) Quasi-arbitrage implies that a synthetic security is more attractive than a natural
security
(d) All of the above

15. Gold is perceived as a hedge against inflation. Thus gold prices and interest rates are
likely to be positively correlated. Gold is also invariably a pure asset. Which of these
statements is true:

(a) Gold futures prices will be lower than gold forward prices
(b) Gold futures prices will be equal to gold forward prices
(c) Gold futures prices will be greater than gold forward prices
(d) The answer depends on the storage cost

75
16. Interest rates and bond prices are inversely related. Thus, which of these statements is
true:

(a) T-bond futures prices will be lower than T-bond forward prices
(b) T-bond futures prices will be equal to T-bond forward prices
(c) T-bond futures prices will be greater than T-bond forward prices
(d) The answer depends on the maturity of the T-bond.

17. Which of these statements is true if a market has N products on which futures contracts
are being traded:

(a) There are N ways of creating a synthetic T-bill

(b) There are less than N ways of creating a synthetic T-bill
(c) There are more than N ways of creating a synthetic T-bill
(d) Futures contracts cannot be used to create synthetic T-bills

18. Consider futures contracts on a non-dividend paying stock. The stock price last month
was Rs 80 and the interest rate for the time period till maturity was 4%. Today the stock
price is Rs 90 and the interest rate for the remaining time to maturity is 5%. Both the
interest rates are periodic rates and not annual rates. Which of these statements is true:

(a) The futures price last month was Rs 83.20

(b) The current futures price is Rs 94.50
(c) The current value of a long futures contract entered into last month is Rs 10.7619
(d) All of the above

76
19. Assume that an arbitrageur initiates a cash and carry strategy by borrowing for a short
duration and periodically rolling forward till the date of maturity of the forward contract.
Which of these statements is true:

(a) If interest rates decline the ex-post profit will be higher than the ex-ante profit
(b) If interest rates decline the ex-post profit will be lower than the ex-ante profit
(c) If interest rates do not change the ex-post profit will be less than the ex-ante profit
(d) None of the above

20. The market is anticipating a dividend payout of D during the life of the contract. The
actual dividend is higher. Which of these statements is false:

(a) The ex-post profit will be higher than the ex-ante profit for a cash and carry arbitrage
strategy
(b) The ex-post profit will be lower than the ex-ante profit for a reverse cash and carry
strategy
(c) Reverse cash and carry arbitrage will always lead to a loss if the dividend payout
were to be higher than anticipated
(d) None of the above

21. Consider a forward contract on a dividend paying stock. Which of these statements is
true:

(a) If the futures price is equal to the spot price, the interest cost is equal to the dividend
(b) If the futures price is equal to the spot price, the interest cost is equal to the present
value of the dividend
(c) If the futures price is equal to the spot price, the interest cost is equal to the future
value of the dividend
(d) The futures price cannot be equal to the spot price for a dividend paying stock

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22. Consider the cost of carry model for a contract on a dividend paying stock. Which of
these statements is true:

(a) There is no upper limit on the forecasted dividend

(b) The future value of dividends during the life of the option cannot exceed the future
value of the current spot price
(c) The future value of dividends during the life of the option cannot exceed the present
value of the current spot price
(d) None of the above

23. Which of these statements is true for forward contracts on a dividend paying stock:

(a) The market must be in contango

(b) If the market is in backwardation the future value of the dividends must be greater
than the interest cost
(c) If there is a positive dividend the market cannot be in contango
(d) None of the above

24. Assume the borrowing rate is higher than the lending rate. Which of these statements is
true:

(a) If cash and carry arbitrage is profitable, then reverse cash and carry arbitrage will
not
(b) If reverse cash and carry arbitrage is profitable, then cash and carry arbitrage will
not
(c) Both cash and carry and reverse cash and carry strategies expose the arbitrageur to
financing as well as payout risk
(d) All of the above

25. Which of these statements is true.

(a) The delivery price may be lower than the forward price
(b) The delivery price may be higher than the forward price
(c) The delivery price may be equal to the forward price
(d) All of the above

26. Assume that the interest rate remains constant for the life of the forward contract, and
that the asset is non-dividend paying. Which of these statements is true:

(a) If the delivery price is less than the forward price, the spot price has increased
(b) If the delivery price is greater than the forward price, the spot price has decreased

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 (c) If the delivery price and the forward price are equal, the spot price must be un-
changed
(d) None of the above

27. Assume that the interest rate remains constant for the life of the forward contract, and
that the asset is dividend paying. The dividend is paid at the time of expiration of the
contract. Which of these statements is true:

(a) If the delivery price is less than the forward price, the spot price has increased
(b) If the delivery price is greater than the forward price, the spot price has decreased
(c) If the delivery price and the forward price are equal, the spot price must be un-
changed
(d) None of the above

28. Which of these statements is true. Assume that the interest rate is a constant:

(a) If a long forward contract has a positive value, a similar short forward contract must
have a negative value
(b) For a non-dividend paying stock, if the stock price remains constant, the value of a
long position will steadily decline
(c) For a dividend paying stock, if the dividend is paid at the time of expiration of
the contract, and the stock price remains constant, the value of a long position will
steadily decline
(d) All of the above

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29. Consider a non-dividend paying stock. Assume the borrowing rate is higher than the
lending rate, and that neither cash and carry nor reverse cash and carry arbitrage is
profitable. Which of these statements is true:

(a) The implied repo rate may be equal to the implied reverse repo rate
(b) The implied repo rate will be equal to the implied reverse repo rate
(c) The implied repo rate cannot be equal to the implied reverse repo rate
(d) The answer depends on the spot price

30. Which of these statements is true:

(a) If a market is in contango, the stock must be non-dividend paying

(b) If the market is in contango, the interest cost is greater than the future value of the
dividends
(c) If the market is in contango, cash and carry arbitrage cannot be profitable
(d) None of the above

31. Which of these products is likely to have a positive convenience value:

(a) Gold
(b) Silver
(c) Copper
(d) None of the above

32. Which of these statements is true:

(a) A short sale is betting against the long-run direction of the market because over
time stocks should appreciate on account of inflation
(b) If there is an annual general meeting during the period of the short sale, the lender
of the stock loses the right to vote
(c) If a stock is sold short and there is a 5:2 stock dividend, the borrower must return
seven shares to the lender
(d) All of the above

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33. Which of these statements is true:

(a) Short-selling is a very profitable business for the broker

(b) All short-sellers can negotiate short-interest rebates from their brokers
(c) The amount of collateral given to the broker is equal to the proceeds of the short
sale
(d) None of the above

34. Which of these statements is true:

(a) The convenience value varies from beholder to beholder

(b) The convenience value cannot be quantified
(c) If the convenience value is zero the market for commodity futures must be in con-
tango
(d) All of the above

35. Consider futures contracts on commodities. Which of these statements is true:

(a) If the futures price is equal to the spot price, the asset must be a consumption asset
(b) If the futures price is equal to the spot price, the convenience value must be equal
to the future value of the storage costs
(c) If the futures price is equal to the spot price, the convenience value must be equal
to the interest cost for the period
(d) None of the above

36. Which of these statements is true:

(a) At inception the value of a forward contract is always zero

(b) After inception the value of a forward contract may be zero
(c) If at a point in time, the value of a forward contract is zero, the forward price must
be equal to the delivery price
(d) All of the above

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37. Which of these strategies requires the freedom to short sell:

(a) Cash and carry arbitrage

(b) Reverse cash and carry arbitrage
(c) Reverse cash and carry quasi-arbitrage
(d) None of the above

38. Quasi-arbitrage strategies can be used to set up:

(a) A long synthetic spot position

(b) A long synthetic forward position
(c) A long position in a synthetic T-bill
(d) All of the above

39. Which of these statements is true:

(a) Financial assets are usually pure assets

(b) If an asset is pure the convenience value must be zero
(c) Forward contracts on financial assets, may be in backwardation or in contango
(d) All of the above

40. Consider forward contracts on financial assets. Which of these statements is true:

(a) The net carry may be positive

(b) The net carry may be negative
(c) The net carry may be zero
(d) All of the above

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