Question

A bank can borrow or lend money at the same interest rate in the libor market. the 180 day rate is 5.0000% and the 270 day rate is 5.3333% both expressed with continuous compounding and a 365 day year. the 3-month eurodollar futures price quote for a futures contract with a delivery date in 6 months is 94. the size of the eurodollar futures contract is $1 million. use this information to answer this and the next question. which of the following is the correct arbitrage strategy?

a. borrow at the 270 day libor rate, invest at the 180 day libor rate, buy the eurodollar futures contract
b. borrow at the 270 day libor rate, invest at the 180 day libor rate, sell the eurodollar futures contract
c. invest at the 270 day libor rate, borrow at the 180 day libor rate, sell the eurodollar futures contract

Answer 1

The correct arbitrage strategy involves investing at the lower 180-day LIBOR rate and selling the Eurodollar future to lock in a higher rate, but the strategy outlined in the options provided is not correct.

Step-by-step explanation:

To identify the correct arbitrage strategy, one must compare the available interest rates for investing and borrowing and use Eurodollar futures contracts to exploit the difference between expected future interest rates and the current futures price.

The given 180-day LIBOR rate is 5.0000% with continuous compounding, and the 270-day LIBOR rate is 5.3333% with continuous compounding. A Eurodollar futures price of 94 implies an implied interest rate of 100 - 94 = 6% for the underlying 3-month LIBOR starting in 6 months. As the 180-day rate is lower than the implied future rate, the strategy involves investing at the lower 180-day rate now and selling the Eurodollar futures contract to lock in the higher implied future rate. Therefore, one would not want to borrow at the higher 270-day rate when they can borrow at the implied future rate of 6% which is better than both the 180-day and 270-day rates. So, the correct arbitrage strategy is not present in the given options.