Repo Rate & Arbitrage in Futures Pricing

1. Introduction

Arbitrage is the act of buying in a cheaper market and selling in a costlier market to make risk-free profit. In Futures, this depends on the borrowing rate, known as the Repo Rate (or explicit interest rate).

2. Cash-and-Carry Arbitrage (When Future is Overpriced)

This strategy is used when the Futures Price is too high.

The Steps:

1. Borrow Money: At the Repo Rate (say 6%).
2. Buy Spot: Buy the asset in the cash market.
3. Sell Future: Sell the asset in the futures market (at the high price).
4. Hold: Keep the asset till expiry.
5. Deliver: On Expiry, deliver the asset to settle the specific Future.
6. Profit: (Future Price - Spot Price) - Interest Cost.

If this Profit is $> 0$, the arbitrage is successful.

3. Reverse Cash-and-Carry Arbitrage (When Future is Underpriced)

This strategy is used when the Futures Price is too low.

The Steps:

1. Sell Spot: Short sell the asset in cash market (borrowing the share).
2. Invest Proceeds: Lend the money to earn interest.
3. Buy Future: Buy the cheaper futures contract.
4. Expiry: Take delivery from Future and return the borrowed share.

4. Exam Notes: Writing the Answer

Question: "Explain Cash-and-Carry Arbitrage with an example." (10 Marks)

Answering Structure:

1. Condition: "Used when Futures Price > Fair Value."
2. Action: "Buy Spot + Sell Future".
3. Logic: "The profit from the spread covers the interest cost and leaves a surplus."

5. Quiz Time! 🎯

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