Simple Futures/Forward Arbitrage

Discussion in 'Strategy Development' started by Paul_G, Feb 5, 2009.

  1. Paul_G

    Paul_G

    Hi guys,

    I'm reading Hull and there's something I can't really nail down w.r.t. artbitrage.

    F0 - Forward price now
    So - Spot of the underlying asset
    R - IRate.

    The two arb situations are:
    1. F0 > S0.Exp(rt). Here, F0 is too expensive, so I sell the Forward, buy the asset

    2. F0 < S0.Exp(rt). Here F0 is too cheap so I buy the forward and sell the asset.

    Now, in case 2. I sell the asset - but you need to have the asset to sell to take advantage of this - you can't magically obtain the asset.

    Indeed Hull explains this by saying 'Short sales are not possible for all investment assets. As it happens, this does not matter...... ....All that we require is that there are a significant number of people who hold the asset for investment purposes.'

    Now, yes I understand this, but surely this assumption must most hold 'some' value for the arbitrageur holding the asset over someone buying it. Shouldn't the asset holder have some advantage here? - however small.... i.e. wouldn't it be more apparant if there was suddenly a shortage of the asset? Something like bad weather destroying 50% of US crops for example.

    Thanks,
    Paul