Learning Objectives: Describe arbitrageurs' strategy and calculate an arbitrage payoff. Describe some of the risks that can arise from the use of derivatives.
Questions:
24.2.1. A trader at AI Train a high-frequency trading hedge fund, is seeking to exploit mispricing on the statistical arbitrage; she observes the following market prices:
a. Short 1-year futures contracts and long 2-year futures contracts
b. Short 2-year futures contracts and long 1-year futures contracts
c. Short 1-year futures contracts and long the underlying asset funded by borrowing for 1 year at 2% per year
d. Short 2-year futures contracts and long the underlying asset funded by borrowing for 2 years at 2% per year
24.2.2. A 15-month futures contract on an S&P500 equity index is currently trading at USD 4,829. The underlying S&P500 index is currently priced at USD 4,810 and has a continuously compounded dividend yield of 2% per year. The continuously compounded risk-free rate is 5% per year. Assuming no transaction costs, what is the appropriate strategy to earn potential arbitrage profit?
a. Buy the futures contract and buy the underlying.
b. Buy the futures contract and sell the underlying.
c. Sell the futures contract and buy the underlying.
d. Sell the futures contract and sell the underlying.
24.2.3. Below are historical scenarios of financial loss from unauthorized trading in derivatives:
a. Market Risk: Implementing strict market risk limits and daily trading reviews.
b. Operational Risk: Enhancing internal controls, including separation of duties and real-time monitoring of trading activities.
c. Credit Risk: Establishing better counterparty risk assessments and collateral management.
d. Liquidity Risk: Enforcing liquidity constraints and regular stress testing of positions.
Answers here:
Questions:
24.2.1. A trader at AI Train a high-frequency trading hedge fund, is seeking to exploit mispricing on the statistical arbitrage; she observes the following market prices:
- Current price of a financial asset: USD 2,000
- 1-year futures contract price: USD 2,040
- 2-year futures contract price: USD 2,090
- The term structure of risk-free interest rates is flat at 2% per year.
a. Short 1-year futures contracts and long 2-year futures contracts
b. Short 2-year futures contracts and long 1-year futures contracts
c. Short 1-year futures contracts and long the underlying asset funded by borrowing for 1 year at 2% per year
d. Short 2-year futures contracts and long the underlying asset funded by borrowing for 2 years at 2% per year
24.2.2. A 15-month futures contract on an S&P500 equity index is currently trading at USD 4,829. The underlying S&P500 index is currently priced at USD 4,810 and has a continuously compounded dividend yield of 2% per year. The continuously compounded risk-free rate is 5% per year. Assuming no transaction costs, what is the appropriate strategy to earn potential arbitrage profit?
a. Buy the futures contract and buy the underlying.
b. Buy the futures contract and sell the underlying.
c. Sell the futures contract and buy the underlying.
d. Sell the futures contract and sell the underlying.
24.2.3. Below are historical scenarios of financial loss from unauthorized trading in derivatives:
- John Rusnak at Allied Irish Bank lost USD 700 million in foreign currency trading, concealing losses through fictitious option trades.
- Nick Leeson at Barings Bank lost about USD 1 billion, making large unauthorized bets on the future direction of the Nikkei index and hiding losses from his superiors.
- Jérôme Kerviel at Société Générale speculated on equity indices, leading to losses of about USD 7 billion while appearing to be engaging in arbitrage.
a. Market Risk: Implementing strict market risk limits and daily trading reviews.
b. Operational Risk: Enhancing internal controls, including separation of duties and real-time monitoring of trading activities.
c. Credit Risk: Establishing better counterparty risk assessments and collateral management.
d. Liquidity Risk: Enforcing liquidity constraints and regular stress testing of positions.
Answers here:
