Chartered Financial Analyst (CFA) Practice Exam Level 2

What is Reverse Carry Arbitrage?

1. Buying securities and holding them long-term

2. Buying underlying security and selling short

3. Only working with liquid assets

4. Creating risk-free portfolios

The correct answer is: Buying underlying security and selling short

Reverse Carry Arbitrage involves a strategy where an investor simultaneously buys the underlying security while selling it short, taking advantage of pricing discrepancies between the spot price and the futures price. In this scenario, the investor is looking to profit from the difference in interest rates or the cost of carry associated with holding the underlying asset versus the short position. This approach is typically employed when the futures price of a security is higher than its expected future spot price, creating an opportunity. By buying the underlying asset, the investor aims to lock in a lower price, while simultaneously shorting the same asset to capitalize on the higher futures price until the prices converge at the contract's expiration. This strategy hinges on the premise that discrepancies in pricing will eventually correct themselves, allowing for a risk-free profit when executed correctly. The other choices do not accurately represent the concept of Reverse Carry Arbitrage. For instance, holding securities long-term does not address the specific mechanics of arbitrage. Working only with liquid assets speaks to market characteristics rather than the arbitrage strategy itself. Creating risk-free portfolios is a broader concept and does not focus on the particular transaction of buying and shorting the same asset. Therefore, the correct answer reflects the essential nature of Reverse Carry Arbitrage by focusing on the simultaneous buying