Let us recollect, what we have discussed in
the previous article:
a.
We assumed a risk-free rate of 6%.
b.
We assumed the price of 10 pencils at $5.00
(USD).
c.
We assumed that the forward prices will grow at
risk-free rate.
d.
We got the forward price after one year to be $5.31,
using the formula of S0 x erT
e.
We assumed that some commodities are not worth
storing.
f.
We assumed that prices of such commodities
remain constant.
g.
In such scenario, there exists an arbitrage.
The arbitrage opportunity in such scenarios
exists in the following form:
a.
Sell the commodity today, at time (T0)
b.
At time (T0), Get those proceeds and
invest them for a period of “T”, at risk-free rate
c.
At time (T0), enter into a long
forward contract
d. At time
(TT), use those proceeds to buy the commodity as per the long
forward agreement
(Please go to the previous article to
understand how arbitrage opportunity existed in such scenarios)
What we concluded?
a.
We concluded that arbitrage opportunity exists,
only through theoretically, but not practically.
b.
We understood that the lender of pencils will
not lend those pencils without any return or benefit.
Now, how much does he expect, and is there
any arbitrage in realistic scenario?
a. No, there cannot be arbitrage. Because, the
prices of pencils is assumed to be constant for the next one year.
b.
The trader borrowed 10 pencils (worth $5.00) and
sold them in the cash market and invested for 6% (risk-free rate) for one year.
c. After one year, he will get $5.31 dollars on
investment and buy those pencils again at $5.00 either in cash market (prices
remain constant) or through long forward agreement.
d.
He creates an arbitrage profit of $0.31 on those
10 pencils contract.
The lender of the pencils expects some
return while lending those pencils...How much he will expect?
a.
Can he expect 4%, when the risk-free rate in the
market is 6%?
b.
Can he expect 5%, when the risk-free rate in the
market is 6%?
c.
Can he expect 6%, when the risk-free rate in the
market is 6%?
d.
Can he expect 7%, when the risk-free rate in the
market is 6%?
Let us discuss all those cases, one by
one...
Risk-free rate 6%
|
S0 =
$5.00 (for 10 pencils)
|
Value of forward
agreement, using the formula of:
S0
x erT
|
|
When Lender expects
4%
|
The
lender expects 4%, the cost of borrowing those pencils will be $5.20; The
trader with short selling today will get after one year $5.31, still there is
an arbitrage profit of $0.11 dollars on this whole trade.
|
||
When Lender expects
5%
|
The
lender expects 5%, the cost of borrowing those pencils will be $5.26; The
trader with short selling today will get after one year $5.31, still there is
an arbitrage profit of $0.05 dollars on this whole trade.
|
||
When Lender expects
6%
|
The
lender expects 6%, the cost of borrowing those pencils will be $5.31; The
trader with short selling today will get after one year $5.31; The cost of
borrowing the pencils is equal to the value of investment proceeds.
THE ARBITRAGE OPPORTUNITY CEASES TO EXIST
|
||
When Lender expects
7%
|
The borrower will not go for such a trade where the cost of borrowing is
higher than the benefit of trade. For the lender, there is no problem. He will be ready to lend @7%, when the risk-free rate is 6% in the market.
|
In the market, the lender of the pencils
will expect at least a benefit of minimum 6%, that is equal to the risk-free
rate and with this the arbitrage opportunity ceases to exist. The remaining
things, I will discuss gradually in next
articles.
Thanks a lot for your patient watch...
Surya
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