Portfolio Management Speculation & Arbitrage

Exercises with solutions

Exercise 1

The following set of ST 3 Sterling interest rate futures prices were observed on the 31st July:

September 97.10
December 97.00
March 97.25

Face value of 1 contract = £500,000, tick size = 0.01% = 1 basis point

a) Show that the tick value is £12.50

On 31st July a trader A buys the 1 December futures based on the mispriced middle contract,
which he hopes to sell a few days later and make a profit.

b) What is the Trader A’s rationale for buying the middle contract?

c) Trader B believes that the December future’s price will rise relative to the September
future’s price and undertakes a spread trade. What is the price of the Sep-Dec spread? Does
B buy or sell the spread? Justify.

d) Design a strategy that trader C might follow given that the Middle contract looks
mispriced relative to surrounding contracts.

5 days later the following prices are observed:

September 96.10
December 96.25
March 96.35

e) The above three trades are closed after 5 days. Name the each type of trade. Calculate the
profit/loss of each. Comment on the relative success of each strategy.

a) 1 tick = 0.01% change in interest rate on £500 000 for 3 months.

3m interest on £500 000 = (0.01% of 500 000)/4 =£12.50

b) The December Futures is the middle contract but its Price is below both and is clearly too
low. Trader A is expecting the December Futures price to rise and lie between the other two
so he is going buy (to open) and expects to sell (to close) later when the price has moved up.

c) Sep-Dec Spread Price = PDEC – PSEP = 97.00 – 97.10 = – 0.10. Trader B believes the Dec
Price will rise above the Sep Price i.e. spread will increase (become less negative) so buys the
spread @ –0.10.

d) Trader C’s strategy will depend on evaluation of the two spreads:

Sep–Dec spread = 97.00 – 97.10 = – 0.10 (-10 ticks) is low relative to the Dec-Mar spread
which is 97.25-97.00 = 0.25 = 25 ticks

– Trader C expects that:

Sep–Dec spread will widen (become less negative), and simultaneously
Dec–Mar spread will narrow (become less positive).

– Trader therefore:
buys Sep–Dec spread, and sells Dec–Mar spread.

Trader C is selling outer (further) spread and buying nearer (inner) spread, so we say he is
selling butterfly spread.

When middle contract adjusts he expects to buy back the butterfly spread and make a profit.

e) Trader A: Trade is an Open trade.

Day 0: Buy Dec future @ 97.00 and on Day 5 sell Dec future 96.25 (an apparent loss).
(PSell −PBuy )∗tick size (96.25−97.00)∗12.50
Profit = = = −£937.50 (loss)
tick value 0.01

Trader B: Spread Trade: Day 0 buy spread @ –0.10; Day 5 sell at (96.25 – 96.10) = 0.15
(PSell − PBuy ) ∗ tick size (0.15 − −0.10) ∗ 12.50
Profit = = = £312.50
tick value 0.01

Trader C: Butterfly Trade

Day 0: Sell the butterfly:

Butterfly Price = Price(Mar) – 2xPrice(Dec) + Price(Sep) = 97.25 – 2(97.00) + 97.10 = 0.35
Psell = 0.35 = 35 ticks OR
Pwings – Pbody = = 97.25 + 97.10 – 2(97.00) = 0.35

Day 5: Buy the butterfly

Butterfly Price = 96.35 – 2(96.25) + 96.10 = –0.05 = –5 ticks
Profit = 40 ticks
(PSell − PBuy ) ∗ tick size (0.35 − −0.05) ∗ 12.50
Profit = = = £500
tick value 0.01

A’s strategy failed because an open trade is dependent on correctly anticipating the absolute
movement of price rather than relative movement as in B’s Spread or C’s butterfly trade.
 ARBITRAGE:

Exercise 3:
(a) Distinguish between box arbitrage and conversion arbitrage strategies.

(b) The table below shows some no-arbitrage conditions and violations of these
conditions that provide arbitrage conditions. Complete the table to show how the
arbitrage conditions can be exploited.

Complete the following table with details of how to exploit the arbitrage conditions

Futures No arbitrage condition Violation of Actual Pf

ST3

Arbitrage Process
Opening Position (Day
0)
After 1m

Closing Position
(after T months)

Futures No arbitrage condition Violation

STG
Sterling
Currency
Arbitrage Process
Opening Position
(Day 0)
Closing position (after
T years)

Options Put-Call Parity condition Violation

(No arbitrage condition)
 Solution on next page See Videoed Solution for more details

Solution:

(a) Box arbitrage strategies use derivatives only and not the underlying of the derivatives.
Conversion strategies use a mix of the underlying and their derivatives.

(b)
Futures No arbitrage condition Violation
ST3

Arbitrage Process
Opening Position (Day 0) Pf too high ➔ sell futures.
Borrow @ rs1 for 1m & deposit @ rs4 for 4 months. Also Sell the futures @ Pf.
After 1m Roll over borrowing for a further 3 months after the one month:
To do this means Payoff the 1 month loan with the borrowing for a further 3
months @ (100 – Pf)%.
Closing Position The 4 month deposit @ rs4 made on day 0 matures. The ST3 futures matures. The
(after T months) proceeds from the 4 month deposit is used to service the sale of the futures. The
excess is the arbitrage profit realised at the end of the trade.

Futures No arbitrage condition Violation

STG
Sterling
Currency
Arbitrage Process
Opening Position Futures Price too low so Buy.
(Day 0) Pf is too low so buy futures. Borrow sterling @ r£, Sell sterling at PS & Deposit
$s @ r$ for T years in Eurodollar account.
Closing position (after T Eurodollar account matures sterling loan both mature and futures expires.
years) Proceeds from Eurodollar deposit used to buy Sterling @ P f, which is used to
payoff the sterling loan. The remainder is the profit realised at the end.

Options Put-Call Parity condition Violation

(No arbitrage condition)
S + P = C + PV(X) S < C – P + PV(X)
Conversion Arbitrage Process
Opening Position Buy underlying share @ S. Sell Call with exercise price X @ C, Sell Bond @
(Day 0) PV(X) and buy Put with exercise price X @ P. Bank net proceeds of (C +PV(X) –
P – S) > 0
Closing position (after T Sell the Share @ ST.
years) If the Call is in the money pay the holder the Intrinsic value = S T – C. Otherwise
Call abandoned.
If the Put is in money exercise the Put to receive the Intrinsic value = X – ST.
Otherwise abandon the Put.
Pay the Bond Holder the par Value of X.
The net money position will be zero.

Continued on the next page

Exercise 22

(a) Use the Put-Call Parity relationship: S + P = C + PV(X) to show how a synthetic
share can be constructed.
(b) Assume an interest rate of zero. Suppose a Share has a current price of 106p.
Suppose a Call and a Put with the same exercise price, X = 100 are priced at 12p
for the Call and 2p for the Put.
i. What is the price of the synthetic share.
ii. Identify an arbitrage opportunity and show how you would exploit it.
iii. By considering the cash position now and at expiry what is the profit and
when is it realised?
iv. Suppose the actual share price at expiry is 110p what action is needed at
expiry?
v. What type of arbitrage is this (Box/conversion)? Explain.

Solution presented below, see also videoed solution.

Ex 22.

(a) Put-Call Parity relationship is: S + P = C + PV(X).

Rearrange this equation to make S the subject:
S = C + PV(X) – P
So to construct a long synthetic Share:
• Buy a Call with exercise price X.
• Buy a Zero Coupon Bond with a par value of X.
• Sell a Put with exercise price X.

(b) (i) With C = 12p, X = 100p, P = 2p the price of the synthetic share is:
C + X – P = (12 + 100 – 2)p = 110p.
(ii) Actual share price, S = 106p; Synthetic share price is 110p.
So buy actual share @ 106p and sell synthetic share @ 110p.
(iii) Cash Position now:
Buy actual share @ 106p
Sell synthetic share i.e.
Sell 100p Call @ 12p
Sell Bond @ 100p
Buy Put @ 2p
Cash Position Now: +4p

At Expiry:

Payoff at Expiry
Security ST < 100 ST ≥ 100
Short Call, C 0 100 – ST
Long Put, P 100 – ST 0
Short Bond, X – 100 – 100
Long Actual Share ST ST
Cash Position 0 0

So a profit of 4p is made @ the opening stage of the trade.

(iv) If the actual share price at expiry is 110p then (see ST ≥ 100 column)
• the short Call will be in the money by (100 – 110)p = -10p
and the holder of the Call be given the payoff of 10p.
• The long Put will be out of the money and will be abandoned.
• The Bond with a par value of 100p will be delivered.
• The actual share will be sold at ST = 110p.
Net Cash position = 0p

(v) As this strategy has used the Call and Put derivatives and the underlying share,
The actual Share it is an example of Conversion Arbitrage.
Exercise 23

You observe the following set of bid-offer* money market interest rates and Sterling ST3
(STIR) Futures prices with 1 month to expiry:
(*Note In bid-offer rates borrowing is at the higher rate and depositing is at lower rate)

Interest rates (%) Futures prices

1-mo. 2.05-2.10 June (1 mo. to expiry) 97.95
4-mo. 2.10-2.15

a) Can you identify the arbitrage possibility? If so, how would you implement it?

b) Calculate the arbitrage profit based on 10 futures contracts.

a) The futures price of 97.95 implies an interest rate of (100 – 97.95)% = 2.05%.
This allows 2 choices:

Choice 1: Borrow £ for 1 month @ 2.10% and then for a further 3 months by selling
futures @ 2.05% and deposit the borrowing for 4 months @ 2.10% .

Choice 2: Borrow £ for 4 months @ 2.15% and deposit borrowing for 1 month @
2.05% rolled over into a 3month deposit by buying the futures @ 2.05%.
b)
Choice 1 exploits borrowing rate by selling the futures so provides an arbitrage
opportunity viz:
Cost of borrowing a £ for 1 month @ 2.10% and rolled over into a borrowing of @
0.021 0.0205
2.05% for a further 3 months = (1 + 12 ) (1 + 4 ) = £1.0069
0.021
Revenue from depositing £ for 4 months @ 2.10% = (1 + 3 ) = £1.0070
Profit on a £ = £0.0001
Profit on 10 contracts of £500 000 each = £500 000*0.0001*10 = £500.