Theoretical relationship

You are required to identify any mispricings in the value of the futures contract. Once identified, you are required to take a position and hold it without any further adjustments until they wish to exit the market and (hopefully) make a profit. Q1. In your next tradelab session, you will try to work out if there is an arbitrage opportunity in Westpac shares and Westpac share futures. You are going to trade on the 6th of march, while the nearest to delivery futures contract on Westpac share expires on 27 April 200x, and the risk free rate of return is 6.32% p.a. What should be the difference between the price of WBC shares and WBC futures if the share price is $27.00? What if the share price is 27.50? Q2. What arbitrage strategies can you think of if the prices of futures and shares deviate from their theoretical relationship? What actions will you take to make a profit out of this arbitrage opportunity? How would you modify your strategy if the cost of trading (what is “cost of trading”?) is 6.5 cent per share? Your job is to monitor the trading screen and discover profit opportunities and trade on them. Trading rules: - Each trader is only allowed to execute up to 2 trades for Westpac shares and up to 2 trades for Westpac futures during the whole trading session. This means you should only trade when you observe arbitrage opportunities. If there is no such opportunity you should not trade. - Assume the Westpac futures contract has a contract size of 1 share. Each time when you trade, you should only trade 1 share and/or 1 contract. You will be able to download your transaction records from moodle. Use your transaction records to conduct an analysis of the arbitrage opportunity of the trading session as well as your performance. In particular, answer: 1. Were there any arbitrage opportunities during the trading session? 2. Did you capture the opportunities, if there is any? 3. If yes, what was the gross profit on your arbitrage transaction(s)? What was the net profit (net of transaction costs) of your arbitrage transactions? If the cost of trading per transaction was 6.5 cents, what would happen to your arbitrage profit? 4. If no, why you did not capture the opportunity? What you will do to improve if you are given another chance? Assume you are given another chance, explain what you will do and provide relevant discussions to questions in (i). 5. If there is no arbitrage opportunity 6. Demonstrate why this is the case? 7. What must happen to generate an arbitrage opportunity?



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