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CHAPTER 9: FUTURES ARBITRAGE STRATEGIES
MULTIPLE CHOICE TEST QUESTIONS
1. The transaction designed to exploit mispricing in the relationship between futures and spot prices is called
a. a repurchase agreement
b. a hedge
c. speculation
d. carry arbitrage
e. none of the above
2. The implied repo rate is similar to the
a. internal rate of return
b. cost of hedging
c. yield on the futures contract
d. all of the above
e. none of the above
3. On the basis of liquidity, the best futures contract for hedging short-term interest rates is
a. Treasury bills
b. the prime rate
c. commercial paper
d. Eurodollars
e. none of the above
4. Which one of the following options is not associated with the Treasury bond futures contract?
a. end–of-the-month
b. spread option
c. wild card option
d. quality option
e. none of the above
5. The transaction in which a Treasury bond futures spread is combined with a Fed funds futures transaction is
called a
a. Bond-bill spread
b. MOB spread
c. designated order turnaround
d. turtle trade
e. none of the above
6. The opportunity to lock in the invoice price and purchase the deliverable Treasury bond later is called
a. bond insurance
b. program trading
c. the wild card
d. delivery arbitrage
e. none of the above
7. If the futures price at 3:00 p.m. is 122, the spot price is 142.5 and the CF is 1.1575, by how much must the
spot price fall by 5:00 p.m. to justify delivery?
a. 1.285
b. 1.1102
c. 20.50
d. 17.71
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e. 42.94
8. How is the cost of a delivery option paid?
a. the long pays the short with a cash settlement
b. the short pays the long with a cash settlement
c. a higher closing futures price
d. a lower closing futures price
e. none of the above
9. Find the annualized implied repo rate on a T-bond arbitrage if the spot price is 112.25, the accrued interest is
1.35, the futures price is 114.75, the CF is 1.0125, the accrued interest at delivery is 0.95, and the holding
period is three months.
a. 1.85 percent
b. 0.77 percent
c. 14.77 percent
d. 13.04 percent
e. 2.23 percent
10. If a firm is planning to borrow money in the future, the rate it is trying to lock in is
a. the current forward rate
b. the current spot rate
c. the difference between the spot rate and the forward rate
d. the forward rate at the termination of the hedge
e. none of the above
f.
11. Determine the annualized implied repo rate on a Treasury bond spread in which the March is bought at 98.7
and the June is sold at 99.5. The March CF is 1.225 and the June CF is 1.24. The accrued interest as of March
1 is 0.75 and the accrued interest as of June 1 is 1.22.
a. 5.21 percent
b. 10.03 percent
c. 1.28 percent
d. 2.42 percent
e. 0.81 percent
12. Determine the amount by which a stock index futures is mispriced if the stock index is at 200, the futures is at
202.5, the risk-free rate is 6.45 percent, the dividend yield is 2.75 percent, and the contract expires in three
months.
a. underpriced by 0.64
b. overpriced by 2.5
c. overpriced by 9.76
d. overpriced by 0.64
e. underpriced by 2.5
13. Which of the following is not a risk of program trading?
a. the stocks cannot be simultaneously sold at expiration
b. fractional contracts cannot be purchased or sold
c. the dividends are not certain
d. the stocks cannot be purchased simultaneously
e. none of the above
14. What reason might be given for not wanting to hedge the future issuance of a liability if interest rates are
unusually high?
a. the margin cost will be expensive
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b. you are locking in a high rate
c. transaction costs are higher
d. futures prices are lower
e. none of the above
15. If the stock index is at 148, the three-month futures price is 151, the dividend yield is 5 percent and the interest
rate is 8 percent, determine the profit from an index arbitrage if the stock ends up at 144 at expiration. (Ignore
transaction costs.)
a. 1.89
b. 4.00
c. 7.00
d. 5.11
e. –7.00
16. The transaction in which money is borrowed by selling a security and promising to buy it back in several
weeks is called a
a. term repo
b. overnight repo
c. term arbitrage
d. MOB spread
e. none of the above
17. The end-of-the-month option is
a. the right to exercise an option on the last day of the month
b. an option expiring on the last day of the month
c. the right to deliver during the last seven business days of the month
d. an option that trades only at the end of the month
e. none of the above
18. If you buy both a 30-day Eurodollar CD paying 6.7 percent and a 90-day futures on a 90-day Eurodollar CD
with a price implying a yield of 7.2 percent, what is your total annualized return? (Both yields are based on
360-day years.)
a. 7.25 percent
b. 7.07 percent
c. 10.15 percent
d. 7.75 percent
e. 6.95 percent
19. A deliverable Treasury bond has accrued interest of 3.42 per $100, a coupon of 9.5 percent, a price of 135 and
a conversion factor of 1.195. The futures price is 112.25. What is the invoice amount?
a. 137.56
b. 143.64
c. 161.33
d. 134.14
e. none of the above
20. Determine the conversion factor for delivery of the 7 1/4’s off May 15, 2026 on the March 2010 T–bond
futures contract.
a. 1.225
b. 0.932
c. 1.083
d. 1.127
e. 1.509
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21. Which of the following is not needed when calculating the implied repo rate for stock index futures?
a. futures price
b. conversion factor
c. time–to–expiration
d. spot price
e. none of the above
Use the following information to answer questions 22 through 24. On October 1, the one-month LIBOR rate is 4.50
percent and the two month LIBOR rate is 5.00 percent. The November Fed funds futures is quoted at 94.50. The
contract size is $5,000,000.
22. The dollar value of a one basis point rise in the Fed funds futures price is
a. –$25.00
b. $41.67
c. $5,000
d. $25.00
e. none of the above
23. All of the following are limitations to Fed funds futures arbitrage, except
a. Fed funds rates are determined by Federal Reserve Bank policy
b. basis risk between Fed funds and LIBOR
c. repo rate is variable for the trading horizon
d. settlement is based on average in delivery month
e. transaction costs
24. Compute the dollar profit or loss from borrowing the present value of $5,000,000 at one month LIBOR and
lending the same amount at two month LIBOR while simultaneously selling one November Fed funds futures
contract. Assume that rates on November 1 were 7 percent, there is no basis risk, and the position is unwound
on November 1. Select the closest answer.
a. –$3,150
b. $0
c. $3,150
d. $940
e. –$940
25. Which of the following is a form of program trading?
a. index arbitrage
b. wild card arbitrage
c. triangular arbitrage
d. timing arbitrage
e. none of the above
26. Suppose you observe the spot S&P 500 index at 1,210 and the three month S&P 500 index futures at 1,205.
Based on carry arbitrage, you conclude
a. this futures market is inefficient because the futures price is below the spot price
b. this futures market is indicating that the spot price is expected to fall
c. the spot price is too high relative to the observed futures price
d. the dividend yield is higher than the risk-free interest rate
e. none of the above
27. Suppose you observe the spot euro at $1.38/€ and the three month euro futures at $1.379/€. Based on carry
arbitrage, you conclude
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a. this futures market is inefficient because the futures price is below the spot price
b. this futures market is indicating that the spot price is expected to fall
c. the spot price is too high relative to the observed futures price
d. the risk-free rate in Europe is higher than the risk-free rate in the U. S.
e. none of the above
28. Suppose you observe the spot euro at $1.38/€, the U. S. risk-free interest rate of 0.25% (continuously
compounded), and the European risk-free interest rate of 0.75% (continuously compounded). Identify the
theoretical value of a six month foreign exchange futures contract (select the closest answer).
a. $1.3815/€
b. $1.3765/€
c. $1.3785/€
d. $1.3825/€
e. $1.3755/€
29. Suppose you observe the spot euro at $1.50/€, the U. S. risk-free interest rate of 3.25% (continuously
compounded), and the six month futures price of $1.50/€. Identify the correct implied European risk-free
interest rate (select the closest answer).
a. –3.25%
b. –1.0%
c. 0.0%
d. 1.0%
e. 3.25%
30. Covered interest arbitrage from a U. S. dollar perspective when the euro futures price (expressed in $/€) is too
high involves
a. buying foreign exchange futures contracts
b. selling interest rate futures contracts
c. lending funds in risk-free euro investment
d. selling euros
e. buying euro stock index ETFs
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CHAPTER 9: FUTURES ARBITRAGE STRATEGIES
TRUE/FALSE TEST QUESTIONS
T F 1. The most common means of financing a cash-and-carry arbitrage is a repurchase
agreement.
T F 2. The implied repo rate is the return on an overnight repurchase agreement.
T F 3. The cheapest bond to deliver is the one that has the lowest spot price.
T F 4. It is important to identify the cheapest bond to deliver because it is the one the futures
contract is priced off of.
T F 5. The wild card option exists because of the difference in the closing times of the spot and
futures markets for Treasury bills.
T F 6. Fed fund futures arbitrage is based on the assumption that LIBOR and Fed funds are perfect
substitutes.
T F 7. The timing option will lead to early delivery if the coupon rate is higher than the repo rate.
T F 8. The implied repo rate on a spread is the implicit return on a risk-free spread transaction.
T F 9. A cash-and-carry arbitrage is not risk free unless a repo is available with a maturity equal to
the entire life of the transaction.
T F 10. Transaction costs in program trading are so small that they are not much of a factor.
T F 11. Much of the volume of stock transactions in program trading occurs through the New York
Stock Exchange‘s DOT system.
T F 12. The conversion factor is the price of a bond with a face value of $1, coupon and maturity
equal to that of the deliverable bond, and yield of 6 percent.
T F 13. The unusual volatility that sometimes occurs at stock index futures expirations is because of
the greater uncertainty.
T F 14. Suppose the number of days between two coupon payment dates is 181, the number of days
since the last coupon payment is 100, the annual coupon rate is 8 percent and the par value
is $100,000, then the accrued interest is $2,210.
T F 15. The invoice price of a Treasury bond futures contract is based on the settlement price on
position day and the conversion factor.
T F 16. The opportunity to exercise the quality option will occur when one deliverable bond
becomes more favorably priced than another.
T F 17. If the invoice price of bond A is 122, the invoice price of bond B is 95, the adjusted spot
price of bond A is 127 and the adjusted spot price of bond B is 97, the better bond to deliver
is bond B.
T F 18. The timing option results from the difference in closing times of the spot and futures
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market.
T F 19. If a stock index futures is at 455 and the pricing model says it should be at 458, an
arbitrageur should buy the futures and sell short the stock.
T F 20. Selling an index futures and holding an undiversified portfolio would eliminate
unsystematic risk.
T F 21. The quality option is sometimes referred to as the switching option.
T F 22. An increase in dividends will lower the theoretical value of the stock index futures contract.
T F 23. The coupon assumption for the conversion factor is 8 percent.
T F 24. The settlement price, conversion factor and accrued interest are necessary to calculate the
invoice price.
T F 25. Stock index arbitrage will earn, at no risk, the difference between the futures price and the
theoretical futures price.
T F 26. Foreign exchange carry arbitrage is based on a trader’s expectations regarding purchasing
power parity.
T F 27. In theory, the foreign exchange futures price is based on four parameters only, the spot
foreign exchange rate, the risk-free rate in the domestic currency, the risk-free rate in the
foreign currency, and time to maturity.
T F 28. Covered interest arbitrage relates to program trading and the need to cover the interest on
funds borrowed.
T F 29. The implied interest rate based on stock index carry arbitrage will increase when the spot
price increases, everything else held constant.
T F 30. The implied interest rate based on Treasury bond carry arbitrage will decrease when the
cheapest–to-deliver bond price increases, everything else held constant.
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