Interest Rate Futures Arbitrage
Two broad strategies exist for interest rate futures arbitrage. Interest rate futures contracts on US Treasury bonds or bills allow for the delivery of the actual bond or a close equivalent (Eurodollar futures involve cash settlement).
Take a 20-year bond, with a 8% coupon rate trading at par ($10 000). Assume that this is the deliverable for a three-month futures contract currently trading at $10 200. The annualized risk-free rate is 6%.
Initiation. Sell the futures contract at $10200. Purchase the bond in the spot market at $10000 by borrowing $10000 for three months. The bond can be used for the margin requirement and hence there is no net cashflow.
Settlement. Deliver the bond and receive $10 200 plus accrued interest of $200. Pay back the principal and accrued interest of $10 150 on the borrowings. Net profit is $350.
Take the same scenario but assume a futures contract price of $9700. The first strategy would result in a loss and the trades required to generate a profit are:
Initiation. Buy the futures contract at $9700. Sell or short the bond at $10 000 and invest the proceeds at 6%.
Settlement. Take delivery of the bond and pay $9700 plus $200 in accrued interest. Receive $10 150 from repayments on loan. Net profit is $250.
As usual the action of arbitrageurs will eliminate the arbitrage opportunity and with all other factors unchanged the futures contract should trade at $9950.