An Arbitrage Opportunity? - Suppose that: - Non-dividend-paying stock is priced $4. - The 1-quarter forward price is $42. - The effective annual interest rate is 5%. - Is there an arbitrage opportunity? - Replicate a forward by stock and loan. - Two forward prices, one replicated. - Buy cheap forward, sell pricy forward. An Arbitrage Opportunity - At time 0: - Replication: borrow $40 to buy the stock. - Short the 1-quarter forward on the stock. - In 1 quarter: - Deliver the stock as per the short forward. - Get $42 payment as per the short forward. - Repay the lender $40(1.05)0.25=$40.5. - Arbitrage profit: $42$40.5=$1.5. - Arbitrage from forward price above $40.5