USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
The S&P 500 stock index is at 1300. The annualized interest rate is 4.0 percent, and the annualized dividend is 2 percent. You are currently considering purchasing a two-month futures contract for your portfolio.
-Refer to Exhibit 15.12. If the futures contract was currently available for 1280, indicate the appropriate strategy that would earn an arbitrage profit.
A) long futures and short the index
B) short futures and long the index
C) long futures and long the index
D) short futures and short the index
E) None of these are correct.

Question

Quizplus · Accepted Answer

The futures price should be higher than the spot price due to the cost of carry (interest rate minus dividend yield). The theoretical futures price is 1300 * (1 + (0.04 - 0.02) * (2/12)) = 1304.33. Since the futures contract is available for 1280, it is underpriced. The arbitrage strategy is to buy the futures (long futures) and sell the index (short the index).