How can i earn arbitrage profit in short-selling and derivative without using my own cash in practice?
Hi, i’m a CFA level 1 candidate.
I’m trying to understand how short-selling actually works in practice so i can get the concept. Never been working in the investment industry.
I’m trying to figure out, by reading, and imagine the process.
Please correct me which part i am wrong and add the process if not shown here.
My Understanding of arbitrage profit without using my own cash:
Say, Risk Free Rate is 8% at t=1.
Forward price at t=1 is 106.
Spot price t=0 is 100.
Assuming to ignore costs in level 1 CFA.
From this discrepancy, there is an arbitrage.
I need the money to lend so i can get 8% return at t=1 when it will only cost 106 at t=1.
I need a contract that i can buy the asset at 106 at t=1.
I don’t have this cash to buy the asset.
To get this cash, i can get from short-sell the asset.
At initiation,
Need to short-sell the asset.
I enter the Security Lending Agreement (SLA) to borrow the asset that is worth 100.
Now i own the asset and sell it at 100. I get 100 cash.
Lend the cash at RFR 8%. Pledge this investment as collateral for the lender of the asset.
Enter long position on the Forward contract on this asset, so i can buy the asset at expiration at 106.
At expiration,
My investment matures at 108.
Take it out from the pledge to pay the Forward contract so i can get the asset and return the asset to the lender. All done at the same time.
Now i have the asset returned and cash 2 (=108-106).
Am i right?
(I deliberately lay out every detail in the steps to understand the concept)