Question

On May 1, the one-month T-bill rate is 4.0% and the two-month T-bill is 5.0%. Assume that fed funds futures contracts trade at a 25 basis point rate under one-month T-bill rate at the start of the delivery month. The June fed funds futures is quoted at 94.75. Assuming no basis risk between fed funds and one-month T-bill at the start of the delivery month. Assume that one-month T-bill rate on June 1 was 7%. Contract size is $5,000,000. You are going to use a cash and carry arbitrage strategy to identify whether an arbitrage opportunity is available. Be sure to illustrate the arbitrage strategy for one contract.On June 1, what cash-carry transactions will you take?

Group of answer choices
a)Buy one June Fed funds futures contract; repay the two-month T-bill rate loan; sell the one month T-bill
b)Sell one June Fed funds futures contract; borrow at two-month T-bill rate; buy the one month T-bill
c)Sell one June Fed funds futures contract; borrow at one month T-bill rate; buy the two-month T-bill
d)Buy one June Fed funds futures contract; repay the one month T-bill rate loan; sell the two-month T-bill

Answer 1

On June 1, an arbitrageur should sell one June Fed funds futures contract, borrow at the lower two-month T-bill rate, and buy the higher-yielding one-month T-bill to lock in a risk-free profit. This is done by exploiting the difference between the implied fed funds rate from the futures contract and the actual one-month T-bill rate.

Step-by-step explanation:

On June 1, the appropriate cash-carry arbitrage strategy would be to sell one June Fed funds futures contract, borrow at the two-month T-bill rate, and buy the one-month T-bill. This strategy is chosen because the futures contract is implying a fed funds rate of 5.25% (100 - 94.75). Since the one-month T-bill rate on June 1 is 7%, by borrowing at the lower two-month rate, buying the higher-yield one-month T-bill, and selling the futures contract, an arbitrageur can lock in a risk-free profit.

The steps for cash and carry arbitrage would be:

1. Sell the June fed funds futures contract, locking in the implied rate of 5.25%.
2. Borrow funds at the current two-month T-bill rate of 5%.
3. Use the borrowed funds to purchase the one-month T-bill yielding 7%.
4. On the settlement date, deliver the funds at the agreed upon futures rate, repaying the borrowed amount at the two-month rate, and pocketing the difference between the 7% yield earned on the T-bill and the costs of borrowing.