Arbitrage, Replication, and Cost of Carry: practice question

The one-year forward price of Ordway Timber stock is quoted at $54.10, while its one-year no-arbitrage forward price computed from the spot and the risk-free rate is $52.00. To exploit this mispricing, an arbitrageur should:

1. buy the forward, short-sell the stock, and lend the proceeds
2. buy the forward and buy the stock with borrowed funds
3. sell the forward, buy the stock with borrowed funds, and repay the loan at maturity

Show answer and explanation

Correct answer: C

Explanation: C is correct: the forward is overpriced, so a cash-and-carry arbitrage of selling the forward, borrowing to buy the stock, and delivering at maturity earns 54.10 − 52.00 = 2.10 risk-free. A is wrong because that is the reverse cash-and-carry used when the forward is underpriced. B is wrong because both positions gain or lose together as the stock moves, so nothing is locked in.