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Answer: Trader A makes a profit of ST Ӎ1,000 and Trader B makes a profit of max(ST Ӎ1,000, 0) – 100 where STis the spot price of gold in one year. Trader A does better if STis above $900 as indicated in Figure S1.3. Figure1.3: Profit to Trader A and Trader B in Problem 1.24 2. Assume that the spot price for gold is $1,200 per ounce and the gold futures contract for one year delivery is trading at $1,270. The risk-free interest rate is 5% per year. Can you arbitrage? How? Answer: Theoretical futures price F = 1,200*e(0.05*1)= $1,261.53 Since the actual futures price in the market is $1,270 > $1,261.53, it is overpriced so you can arbitrage Today: (1) Borrow $120,000 at 5% for one year to buy 100 ounces of gold at $1,200 (2) Sell a futures contract on gold at $1,270 per ounce (one year delivery) In one year: (1) Make the delivery and collect $127,000 (2) Repay the loan (principle plus interest) $126,153 = 120,000*e(0.05*1) (3) Take risk-free profit = $847