Chapter 14, Problem 14AP

To determine

To the effect on the future prices of the deliverable Treasury bond which is selling for 101 on the expiration date provided that the Treasury bond futures contract is selling for 102.

Introduction: An agreement given for an asset to be bought or sold at a particular price and at a specific time in future is called a future contract. It has to have the assets details, the size of the contract, time and place. At the expiry of the contract, the future price would converge to its underlying security's market price. Generally, the future contract is considered as a derivative instrument because its value is dependent on its underlying securities.

Explanation:

Suppose the Treasury bond is sold at 101 which means $101\times 1000=\$101,000$ and the Treasury bond future contract is sold at 102 which means $102\times 1000=\$102,000$ on the expiry of future contract. We can observe that on expiry, the future price is larger than the underlying security which results in an arbitrage opportunity. This situation is explained as follows:

One can spend $101,000 for buying the bond from the market and sell the future contract at the price of $102,000. This transaction will lead to an immediate profit of $102,000-$101,000=$1000 without involving in any risk. Such immediate profits would attract buyers. This would result in a rise in the price of the bond and a decrease in the price of the future contracts. This would stop the arbitrage opportunity by the equal prices of both at the maturity of future contracts.