Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the purpose of Carry Arbitrage?

1. To hedge against currency risk

2. To speculate on interest rate movements

3. To profit by buying underpriced futures contracts

4. To lock in current prices for future sales

The correct answer is: To profit by buying underpriced futures contracts

Carry arbitrage aims to profit from discrepancies between the pricing of financial instruments, typically between the spot price of an asset and the price of a related futures contract. In this context, traders exploit situations where the futures contracts are underpriced relative to the expected future spot price, allowing them to enter into a position where they can buy the underpriced contract while selling the associated asset, resulting in a risk-free profit when the prices converge at expiration. In essence, carry arbitrage is based on the principle of carrying a position until the expiration of the futures contract while taking advantage of the price discrepancies in the market. This strategy is prevalent in various financial markets and can involve currencies, commodities, and even interest rates, depending on the opportunities available. One can also note that the other options relate to different trading strategies and risk management tools that do not align specifically with the mechanics of carry arbitrage. While hedging against currency risk can involve offsetting potential losses in foreign exchange, and speculating on interest rate movements is focused on anticipating changes in interest rates, these concepts do not directly embrace the core concept of profiting from pricing inefficiencies within futures contracts. Similarly, locking in prices for future sales is linked to hedging strategies rather than arbitrage maneuvers