FIN3094/3164
FE II / AFE
Tutorial 2
Suggested Answers
Content Review
Some notations
𝑆0 : Spot price today at 𝑡 = 0
𝐹0 : Theoretical Futures or Forward price today
𝑇: Time until delivery date in years
𝑟: Riskfree interest rate for T
Content Review
Determination of Fair Forward Price:
I. For an investment asset providing no cash income:
𝐹0 = 𝑆0 𝑒 𝑟𝑇
II. For an investment asset providing a known yield, q:
𝐹0 = 𝑆0 𝑒 𝑟−𝑞 𝑇
Q1
Q
A 1-year long forward contract on a non-dividend paying stock
is entered into when the stock price is $40 and the risk-free
rate of interest is 10% per annum, with continuous
compounding.
a. What are the fair forward price and the initial value of the
forward contract?
b. Six months later, the price of the stock is $45 and the risk-
free interest rate is still 10%. What is the fair forward price?
Q1a (Con’t)
Q: What are the fair forward price and the initial value of the
forward contract?
The Forward price is given by (Case I)
𝐹0 = 𝑆0 𝑒 𝑟𝑇
𝐹0 = $40𝑒 0.10×1 = $44.21
The initial value of the forward contract is zero: 𝑉0 = 0
Q1b (Con’t)
Q: Six months later, the price of the stock is $45 and the risk-free
interest rate is still 10%. What is the fair forward price?
𝐹0 = 𝑆0 𝑒 𝑟𝑇
6
0.10×12
𝐹0 = $45𝑒 = $47.31
Q2
Q:
The risk-free rate of interest is 7% per annum with
continuous compounding, and the dividend yield on a
stock index is 3.2% per annum. The stock market index
currently stands at 6,400. What is the theoretical 6-month
futures price of the index? Assuming an index multiplier
or 50 times.
Q2 (Con’t)
Case II, q = 3.2%:
𝐹0 = 𝑆0 𝑒 𝑟−𝑞 𝑇
𝐹0 = 6,400𝑒 0.07−0.032 ×0.5
𝐹0 = 6,522.76
Hence the fair price per future contract is:
𝐹0 = 6,522.7626 × $50 = $326,138.13
Q3
Q.
Assume that the risk-free interest rate is 9% per annum with
continuous compounding and that the dividend yield on stock index
varies throughout the year. In February, May, August and November,
dividends are paid at a rate of 5% per annum. In the other months,
dividends are paid at a rate of 2% per annum. Suppose that the value
of the index on 31 July 2008 was 300. What is the futures price for a
contract deliverable on 31 December 2008?
Month 1 2 3 4 5
August Sept Oct Nov Dec
5% p.a. 2% p.a. 2% p.a. 5% p.a. 2% p.a.
Q3 (Con’t)
Case II, Average dividend yield p. a., q = 3.2%:
𝑟−𝑞 𝑇
𝐹0 = 𝑆0 𝑒
5
0.090−0.032 ×
𝐹0 = 300𝑒 12
𝐹0 = 307.34
Q4
Q:
Suppose that the risk-free interest rate is 10% per annum
with continuous compounding and that the dividend yield
on a stock index is 4% per annum. The index is standing at
400, and the futures price for a contract deliverable in
four months is 405. Is there any arbitrage opportunity?
Q4 (Con’t)
The fair futures price is
4
0.10−0.04 ×
𝐹0 = 400𝑒 = 408.08
12
While the actual futures price is 405.
▪ This shows a riskless arbitrage opportunity as the index
futures is undervalued at 405 relative to its fair price
(408.08)
▪ Appropriate strategy: Long futures; Short sell asset
Q5: Full set forward arbitrage, Case II
Q:
A forward contract on a stock with 6-month expiration is
currently priced at 118. The underlying stock price is RM120
now. The stock has an average dividend yield of 3.5% per year
over the past decade, and the earning distribution is expected
to remain for the foreseeable future. If the continuously
compounded risk-free rate is 7.5% per year, strategize and
describe the actions taken to exploit the arbitrage
opportunity, if any. Determine the arbitrage profit.
Q5 (Con’t)
Determine the fair forward price:
0.075−0.035 ×6/12
𝐹0 = 120e = 𝟏𝟐𝟐. 𝟒𝟐𝟒
▪ The actual forward price is 118, which is lesser than the
fair price of 122.42. Hence, the forward contract is
undervalued at 118.
▪ General arbitrage strategy: Long Forward; Short stock.
Q5 (Con’t)
Actions Now:
▪ Long a forward contract to sell the stock at 118 in 6 months
▪ Short a stock at RM120
▪ Invest the proceeds of RM120 at 7.5% for 6 months
Actions in 6 months:
▪ Receive RM124.5854 from risk-free investment
▪ Pay dividends of RM2.1185
▪ Buy the stock and pay RM118.00
▪ Net arbitrage profit: RM4.4670 per share
SCQ 1
S&P 500 index is now at 3,800. The index is expected to
generate dividend yields of 0.30% and 0.70% in the first
month and the second month, respectively. Assuming the
risk-free rate is 7.0% per annum at continuous
compounding, calculate the theoretical price of a 3-month
forward contract on the equity market index.
Answer: 𝑭𝟎 = 𝟑, 𝟖𝟎𝟗. 𝟓𝟏