Problem Set 1 1
Di Tian
Question 1: Basic Concepts (1/10)
(1) Define what a zero-coupon bond is. (1 sentence)
(2) Define what it means to “reverse a long forward contract”. (at most 2 sentences)
(3) Describe 2 major advantages and disadvantages of future contracts compared to forward
contracts.
(4) Suppose a risk-free bond which pays $120 in 3 months is trading at $100 now. Com-
pute its annual interest rate in both the “simple interest rate” convention and the
“continuously-compounded interest rate” convention.
Question 2: Forwards on Stocks (2/10) Suppose a share in XYZ currently trades for
$100 now and the risk free interest rate is 5% (annual, continuously compounded). There is
a forward contract that allows you to purchase one XYZ share in 18 months.
(1) What is the 18-month forward price of one XYZ share?
(2) Suppose XYZ announces 2 dividend payments of $1 per share in exactly 9 and 18
months (assume the dividends are paid before the execution of the forward contract),
and assume that XYZ stock price does not change upon the announcement, what must
be the new 18-month forward price of the share?
(3) If after the dividend announcement, the 18-month forward price still stays the same,
how would you make arbitrage profit from the market mis-pricing?
(4) Instead, suppose XYZ announces a dividend yield of 1% (annual, continuously com-
pounded), and assume that XYZ stock price does not change upon the announcement,
what must be the new 18-month forward price of the share?
Question 3: The Value of A Forward Contract (2/10) Suppose a share in XYZ
currently trades for $100 on Jan 1st and the risk free interest rate is 10% (annual, continuously
compounded). There is a forward contract that allows you to purchase one XYZ share in
Jul 1st.
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Note: optional questions are for your practice only. They are not counted toward your grades.
1
(1) What is the forward price?
(2) What is the value of the forward contract now on Jan 1st?
(3) Suppose after 3 months (on Apr 1st), the price of one XYZ share stays at $100. Then,
on April 1st, what is the forward price of a forward contract with delivery date on Jul
1st.
(4) Following (3), on Apr 1st, what is the value of the original forward contract (the one
you entered on Jan 1st)?
(5) (Optional) Suppose after 3 months (on Apr 1st), the price of one XYZ share increases
to $110. Then, on April 1st, what is the value of the short position on the original
forward contract (the one you entered on Jan 1st)?
Question 4: S&P 500 Futures Contracts (3/10) Suppose the S&P 500 index is
currently 800 on Jan 1st, the initial margin is 20% and the maintenance margin is 50% of
the initial margin. You wish to enter into a long position for 10 S&P 500 futures contracts.
(1) What is the contract size for S&P 500 Futures? What is the notional value of your
position?
(2) What is the initial margin in dollars?
(3) Suppose you earn an annual continuously-compounded interest rate of 5% on your
margin balance, what is your margin balance after 1 month (on Feb 1st) if the future
price does not change?
(4) Now suppose you do not earn any interest on your margin balance, what is your margin
balance after 1 month (on Feb 1st) if the future price increases by $50?
(5) Following (4), you decide to close out your position on Feb 1st. What would you do
and what is your return on investments (i.e. profits over initial margin)?
(6) Keep assuming no interest and assume that today’s (Jan 1st) futures price is the same
as the spot price, 800. What is the greatest S&P 500 index futures price 1 month from
today at which will you receive a margin call?
Question 5: Forwards and Futures (2/10) Suppose the risk free interest rate is
10% (annual, continuously compounded). That is, the daily interest rate is approximately
1 + rday = e10%×1/365 . There are two contracts on one XYZ share: a forward contract that
allows you to buy one XYZ share on Dec 3 and a future contract (no margin requirement)
that allows you to buy one XYZ share on Dec 3. The spot price of the share on Dec 3 is S3 .
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Suppose you are taking positions on these two contracts on Dec 2. The forward price on
Dec 2 is denoted as F O2 and the future price is F U2 .
(1) If you long one forward contract, what is your initial cost on Dec 2 and what is your
payoff on Dec 3?
(2) If you short one future contract, what is your initial cost on Dec 2 and what is your
payoff on Dec 3?
(3) If you long one forward contract and short one future contract, what is your initial
cost on Dec 2 and what is your payoff on Dec 3? What does no arbitrage condition
tell you about the relationship between F O2 and F U2 ?
Now suppose you are taking positions on these two contracts (recall the maturity dates
are Dec 3) on Dec 1 and selling these positions on Dec 2. The forward price on Dec 1 is
denoted as F O1 and the future price is F U1 .
(4) If you long 1 forward contract on Dec 1, what is the value of the forward contract
(that you entered on Dec 1) on Dec 2? Note this is the amount of money you get if you
sell (close out) the forward contract on Dec 2. (Hint: the value of a forward contract
depends on its original forward price (F O1 in this case), and the forward price now
(F O2 in this case).)
(5) (Optional) If you short 1+r1day future contracts on Dec 1, what is your profit (or loss) on
Dec 2? Note this is the amount of money you get if you close out the future positions
on Dec 2 because closing a future contract earns/costs nothing and simply gives back
the profit you have earned so far. (Hint: the profit / loss of a future contract depends
on its original future price (F U1 in this case), and the future price now (F U2 in this
case).)
(6) (Optional) Consider the portfolio that longs 1 forward contract and shorts 1+r1day
future contracts on Dec 1 and closes out both positions on Dec 2. what is your initial
cost on Dec 1 and what is your payoff on Dec 2? What does no arbitrage say about
the relationship between F O1 and F U1 ?
(7) (Optional) From above, what can we deduce about the prices of forwards and futures
when interest rates are constant?