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CFA Institute Exam CFA-Level-II Topic 1 Question 84 Discussion

Actual exam question for CFA Institute's CFA-Level-II exam
Question #: 84
Topic #: 1
[All CFA-Level-II Questions]

Michelle Norris, CFA, manages assets for individual investors in the United States as well as in other countries. Norris limits the scope of her practice to equity securities traded on U .S . stock exchanges. Her partner, John Witkowski, handles any requests for international securities. Recently, one of Norris's wealthiest clients suffered a substantial decline in the value of his international portfolio. Worried that his U .S . allocation might suffer the same fate, he has asked Norris to implement a hedge on his portfolio. Norris has agreed to her client's request and is currently in the process of evaluating several futures contracts. Her primary interest is in a futures contract on a broad equity index that will expire 240 days from today. The closing price as of yesterday, January 17, for the equity index was 1,050. The expected dividends from the index yield 2% (continuously compounded annual rate). The effective annual risk-free rate is 4.0811%, and the term structure is flat. Norris decides that this equity index futures contract is the appropriate hedge for her client's portfolio and enters into the contract.

Upon entering into the contract, Norris makes the following comment to her client:

"You should note that since we have taken a short position in the futures contract, the price we will receive for selling the equity index in 240 days will be reduced by the convenience yield associated with having a long position in the underlying asset. If there were no cash flows associated with the underlying asset, the price would be higher. Additionally, you should note that if we had entered into a forward contract with the same terms, the contract price would most likely have been lower but we would have increased the credit risk exposure of the portfolio."

Sixty days after entering into the futures contract, the equity index reached a level of 1,015. The futures contract that Norris purchased is now trading on the Chicago Mercantile Exchange for a price of 1,035. Interest rates have not changed. After performing some calculations, Norris calls her client to let him know of an arbitrage opportunity related to his futures position. Over the phone, Norris makes the following comments to her client:

"We have an excellent opportunity to earn a riskless profit by engaging in arbitrage using the equity index, risk-free assets, and futures contracts. My recommended strategy is as follows: We should sell the equity index short, buy the futures contract, and pay any dividends occurring over the life of the contract. By pursuing this strategy, we can generate profits for your portfolio without incurring any risk."

Sixty days after the inception of the futures contract on the equity index, Norris has suggested an arbitrage strategy. Evaluate the appropriateness of the strategy. The strategy is:

Show Suggested Answer Hide Answer
Suggested Answer: B

First, calculate the continuously compounded risk-free rate as ln( 1.040811) = 4% and then calculate the theoretically correct futures price as follows:

Then, compare the theoretical price to the observed market price: 1.035 - 1,025 = 10. The futures contract is overpriced. To take advantage of the arbitrage opportunity, the investor should sell the (overpriced) futures contract and buy the underlying asset (the equity index) using borrowed funds. Norris has suggested the opposite. (Study Session 16, LOS 59.f)


Contribute your Thoughts:

Rosenda
3 months ago
You know, I'm a little skeptical about this whole 'riskless profit' thing. Sounds too good to be true. But hey, if Norris says it's legit, I guess we'll have to trust her on this one.
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Amber
3 months ago
Haha, I bet Norris's client is thrilled to hear about this 'riskless' opportunity. Let's just hope it all adds up and they don't end up with any 'risky' surprises!
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Alyssa
3 months ago
Client: I trust your expertise, Norris. Let's go for it and see how it plays out!
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Kaycee
3 months ago
Norris: Yes, it may seem that way, but this arbitrage strategy is based on solid calculations.
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Daren
3 months ago
Client: Wow, a riskless profit opportunity? That sounds too good to be true!
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Art
4 months ago
Hold up, if the futures contract is overpriced, then this strategy is a big no-no. We need to be really careful here. Norris better have done her homework.
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Carmelina
4 months ago
I see your point, maybe we should trust Norris's expertise in this situation.
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Gerald
4 months ago
But Norris recommended the strategy based on the current market conditions.
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Shonda
4 months ago
Riskless profit? Count me in! I trust Norris's judgment, she's a CFA after all. This is an opportunity we can't afford to miss.
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Dana
3 months ago
Let's go for it! Norris knows what she's doing.
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Louvenia
3 months ago
A) appropriate since the futures contract is underpriced.
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Natalie
3 months ago
B) inappropriate since the futures contract is overpriced.
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Elza
3 months ago
A) appropriate since the futures contract is underpriced.
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Maybelle
4 months ago
Hmm, I'm not so sure. If the futures contract is properly priced, then this arbitrage strategy might not be appropriate. We should double-check the market conditions.
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Vanda
2 months ago
Agreed, we don't want to take unnecessary risks if the futures contract is already priced accurately in the market.
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Willodean
2 months ago
Yes, it's important to make sure the futures contract is not properly priced before engaging in any arbitrage opportunities.
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Elsa
3 months ago
I think we should definitely double-check the market conditions before proceeding with the arbitrage strategy.
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Talia
3 months ago
If the futures contract is overpriced, then the arbitrage strategy might not be the best move for us.
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Della
3 months ago
I agree, it's important to make sure the futures contract is properly priced before proceeding with the arbitrage strategy.
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Shannon
3 months ago
I think we should definitely double-check the market conditions before making any decisions.
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Carmelina
4 months ago
I disagree, I believe the futures contract is overpriced.
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Malcom
4 months ago
This strategy seems legit. If the futures contract is underpriced, we'd be able to make a risk-free profit. Norris knows what she's doing.
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Edelmira
3 months ago
Norris: Great, I'll get everything set up for the arbitrage opportunity.
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Shayne
3 months ago
Client: I trust your expertise, Norris. Let's execute the plan.
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Gene
4 months ago
Norris: I'm glad you agree. We can make some risk-free profit with this strategy.
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Aracelis
4 months ago
Client: Sounds like a good plan. Let's go for it.
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Gerald
5 months ago
I think the strategy is appropriate since the futures contract is underpriced.
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