Susan Baker is a new hire at Crinson Bank’s Chicago office. She has joined the risk arbitrage desk where she will be training to take advantage of price discrepancies in the U.S. T-note futures and spot markets.
Her managing director, Gerald Bigelow, has asked her to calculate parameters for potential arbitrage opportunities for the bank given current market conditions. At the time he asked the question, the cheapest-to-deliver T-notes were at par, with a coupon rate of 8.5 percent. When trading futures, the risk arbitrage desk borrows at 12 percent and lends at 4 percent.
Looking at the calendar, Baker calculates that there are 184 days to the first coupon payment and 181 days from the first coupon payment to the second. Any interest accrued will be paid when the T-note is delivered against the futures contract, but Bigelow asks Baker not to concern herself in the calculations with the impact of reinvesting the coupons or with transaction costs.
To get a feel for the market, Baker first prices a 6-month futures contract that has 184 days to expiration in a “simplified scenario.” She decides to use the same interest rate for borrowing and lending, taking the average of the bank’s borrowing and lending rates. Calculating the futures price under these simplified assumptions, Baker tells Bigelow that the futures contract should trade at 99.7059. Bigelow explains that the futures price is below par even though the spot price is at par because of the benefit to a short seller of receiving the T-note coupon payments.
Having calculated the futures price in the “simplified scenario,” Baker modifies it to reflect the bank’s current borrowing and lending rates, and calculates the corresponding no-arbitrage bands. She tells Bigelow that the lower band will be at 97.7468. Bigelow checks her calculations, confirming that the higher band will be at 101.6294.
Once they know the no-arbitrage bands for current market conditions, Baker and Bigelow check the screen. They see that the market price of the futures contract for which they’ve been calculating no-arbitrage bands is 103. Together, they execute Baker’s first arbitrage play.
Part 2)
Which of the following most accurately describes the arbitrage strategy that Baker and Bigelow executed?
A)Sell futures contract, use proceeds to buy asset, borrow difference, sell asset, buy back futures, and collect difference between finance charges and interest from asset.
B)Borrow funds, buy spot asset, buy futures, deliver asset against long futures, and repay loan and finance charges.
C)Borrow funds, buy spot asset, sell futures, collect accrued interest on spot asset, deliver asset against short futures, and repay loan with interest.
D)Short spot asset, lend proceeds from short sale, buy futures contract, collect principal and interest on loan, pay interest on short asset, take delivery of asset against futures, and replace short asset.

A.S.
B.
Her
C.5
D.
Looking
E.
To
F.”
G.7059.
H.
Having
I.7468.
J.6294.
Once
K.
Part
L.
B)Borrow
M.
C)Borrow
N.
D)Short