Selecting the Financing Rate for Futures Arbitrage

Summary

The note addresses which interest rate to use when evaluating stock index futures arbitrage. It recommends matching the financing rate to the expected life of the trade, typically the time remaining until futures expiry at the outset, because the cash-and-carry position finances or lends against the underlying until settlement. The relevant benchmark is the rate available to large market participants, rather than necessarily the rate available to an individual trader.

The trade may be closed before expiry, so the initial horizon is an assumption rather than a requirement to hold until settlement. The response also cautions that apparent futures arbitrage profits are unlikely to be risk-free in practice, and argues that even large institutions may not capture them reliably. It gives practitioner guidance but no pricing data, rate comparisons, or empirical test, so it does not specify a universal funding rate or quantify execution constraints.

Key ideas

• Choose a financing rate aligned with the expected life of the futures arbitrage trade.
• At inception, futures expiry is a practical horizon because the position settles then.
• Use a rate representative of the borrowing and lending terms available to major market participants.
• An arbitrage position can be closed before expiry, and apparent profits may not be risk-free in practice.

Tags

# interest rate in cost of carry


# interest rate in cost of carry












What interest rates are used in practice in a stock index / futures arbitrage? I've seen cases, when the assumed rate is 3 months LIBOR, but does it mean, that everyone who does the arbitrage can borrow cash at it (or anyone, who can't is automatically out of the game)?

## Answer by Matt Wolf (score 2)

https://quant.stackexchange.com/a/9078

The most prudent way (imho, from a practitioner's point of view) is to chose the rate that applies to the expected lifetime of the trade, which would at the outset be the time to expiration of the futures contract. I am saying that because when you look at the futures contract mechanics the arbitrage is constructed in the way of borrowing/lending in the underlying until the contract is settled and you are obliged to either receive or deliver the underlying (cash or else underlying directly). Chose the rate the large players can borrow/lend at, not the rate you can deal at. Of course above logic does not mean one cannot square the position pre-futures expiration.

Having said that I believe markets are efficient enough to preclude you from deriving a risk free profit from futures arbitrage. Even most sell side investment banks' trading systems are not agile enough to arbitrage futures contracts.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.