On Curriculum, Volume 5, page 203, Question 1.B and 1.C ask for the return in $ and it assumes the cash and carry arbitrage. But Question 2.B and 2.C ask for the return in % and it assumes the cash and carry without borrowing. When is there a borrowing in the cash-and-carry?
When they ask for return in $ I believe you assume there is borrowing. When they ask for the return you can’t include borrowing. The reason is that if you include borrowing your cost is essentially 0 and you can not calculate a return on a 0 cost.
I’m still wondering why you must borrow in Question 1, since both questions have the “cash and carry”.
Same question was asked over here: http://www.analystforum.com/phorums/read.php?13,1234421,1234794 Hoping for a clear explanation here too.
I believe you would always borrow except in the case where they ask you to calculate return. You can’t borrow because you can’t compute return on a 0 starting value (the cost would be 0 since you are borrowing and not spending anything upfront).
I can still get a return($ or %) if I don’t borrow in Question 1?
robbyrazz, thanks. What you said is right. In question 1, why would I have to borrow and it has to be $300? I can still get a return without borrowing, that is, using my own $300 to buy, right?
Difference seems to be due to the mentality of the trader involved. 1 b & c = you are a speculator , seeking to arb the trade, if possible 2 b & c = you are a factory manager checking if the forward rates , spot rates , storage costs to see if you can gain some cost efficiency If you calculate that the return of the trade exceeds the risk free borrowing rate , you’d like to capitalize on the trade. I think both problems are very similar , one forces zero return by assuming perfect arb , the other makes you calculate the fair return and then compare it to borrowing rate. Same conclusion in both cases : under leasing for 1b&c or under storage for 2b&c , there is no arb profit to be made or very small anyway
Neither Question 1 nor Question 2 mention the cash-and-carry “arbitrage”. Correct me if I’m wrong.
But both answers ( i.e. for q 1 and 2 ) from CFAI mention the words cash and carry “arbitrage”.
it is my understanding that you always borrow in cash and carry and NEVER use your own capital
your own capital has opportunity cost too , just equate it to the borrowing cost
Now Question 1 makes sense to me. And it’s similar to 2008 Morning essay question 6. WRT Question 2, no borrowing in the cash and carry arbitrage? One more question: Is “cash and carry” equivalent to “cash and carry arbitrage”? Or it can be a simple trade of buying&carrying the commodity and shorting the forward?
I check all my CFA books. It looks like “cash and carry” IS “cash and carry arbitrage”, although I can’t find out how to borrow at a risk free rate. Question 2 still puzzle me, but I’ll move on. Thanks, janakisri. The opportunity cost helps me.
Can anyone tell me for question 1B, why aren’t they using the lease rate of 1.5% instead of the 5% rate to discount?
Never mind, figured it out. The leasing is a condition to the arbitrage, without leasing the arb won’t work. We have to borrow at the e^-5% to make the payment at time t.