Chapter 5 Solutions

Pricing Forward and Future contracts

Ans: The investor’s broker borrows the share from another client’s account and sells them for the
investor. Eventually the investor has to buy the shares back and the broker replaces them into the
account of the client from whom they were borrowed. The investor must remit to the broker
dividends and other income paid on the shares. The broker transfers these income to the client
from whom they the shares were borrowed. Sometimes the broker runs out of places from which to
borrow from. The investor is then short squeezed and has to close out the position immediately. A
fee may be charged for borrowing shares.
5.2: What is the difference between the forward price and the value of a forward contract?

Ans: The forward price of an asset is the price at which an investor may buy or sell the asset in the
future.
The value of a forward contract is zero at the time of the contract. As the time passes the underlying
asset price changes and the value of the contract may become positive or negative.
5.3: Suppose that you enter into a 6-month forward contract on a non-dividend-paying stock when
the stock is $30 and the risk free interest rat (with continuous compounding) is 12% per annum.
What is the forward price?

Ans:

T = 6/12 = .5
S0 = $30
R = .12
F0 = ?

F0=S0erT

F0=30xe(.12x.5)=31.86
5.6: Explain carefully the meaning of the terms convenience yield and cost of carry. What is the
relationship between futures prices, spot price, convenience yield, and cost of carry?

Ans:
Convenience Yield: A convenience yield is the benefit that comes from holding a phsycial good as
inventory rather than as future contract. Convenience yields apply to consumption assets, products
that are consumed by others rather than held as investments.

Cost of carry: Cost of carry refers to costs associated with carrying value of an investment. It is the
interest cost plus storage cost less the income earned.

F0=S0e(c-y)T
c is the cost of carry, y is the convenience yield, and T is the time to maturity of the futures contract.
5.7: Explain why a foreign currency can be treated as an asset providing a known yield.

Ans:
A foreign currency provides a known interest rate, but the interest is received in the foreign
currency. The value in the domestic currency of the income provided by the foreign currency is
therefore known as a percentage of the value of the foreign currency. This mean that the income
has the properties of a known yield.
5.9: 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 the 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 the forward
price and the value of the forward contract?

Ans:
T=1
S0=40
r= .10
A) Forward price , F0=S0erT = 40xe.10*1 = 44.21
Initial value of the forward contract is 0
B) The delivery price K = 44.21
After six months, the price of the stock is ST= 45
Forward price , F0= 45e.10x.5= 47.31
Value of the forward contract, f = 45-44.21e-.10x.5=2.95
5.11:Assume that the risk free interest rate is 9% per annum with continuous compounding and that the dividend
yield on a stock index varies throughout the year. In February, May, August, and November, dividends are paid at
a rate of 5% per annum. In other months, dividends are paid at a rate of 2% per annum. Suppose that the value of
the index on July 31 is 1,300. What is the futures prices for a contract deliverable in December 31 of the same
year?

Ans:
Risk free rate, r = .09
The future contract is for 5 months, T = 5/12
Average yield for the 5 months is, q = (3*2+5*2)/5 = 3.2%
Spot price of the index , S0=1,300
Future price for the contract, F0=S0e(r-q)T=1,300xe(.09-.032)(5/12)=1331.80
5.12: 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. What arbitrage opportunities does this
create?

Ans:
r=.10
q=.04
S0=400
K=405
F0=400e(.10-.04)x4/12=408.08
Here, K<F0
Buy future contracts, f=(408.08-405)e-(.10-.04)(4/12)= 3.019
Short the shares underlying the index = 400, then invest in a risk free asset =400e .10*(4/12)=413.56
Dividend to the client , 400x(.04/12)*4=5.33
After 4 months, investor buy the share index for 405 and repay the shares borrowed before.
Cash flows = +413.56-3.019-5.33-405=.211
Investor makes = .211
5.14: The 2-month interest rates in Switzerland and the United States are, respectively, 1% and 2%
per annum with continuous compounding. The spot price of the Swiss franc is $1.05. The futures
price for a contract deliverable in 2 months is also $1.05. What arbitrage opportunities does this
create?

Ans:
r=.02
Rf=.01
S0=1.05
F0=1.05e(.02-.01)x2/12= 1.0518 , K<F0
Here, the actual price is lower than what should be in the future
A Swiss arbitrageur should sell Swiss franc, i.g. Fr.100, and buy dollars. The arbitrageur receives = Fr100 * USD1.05 = $105
Invest this amount in a risk-free asset at 2% interest rate = 105e.02x(2/12)=105.35
Arbitrageur buys a future contract to secure the exchange rate = $1.05
At maturity, the arbitrageur converts dollars to Swiss franc at the rate bought with future contract = $105.35 x (1/1.05) = 100.33
The Swiss arbitrageur earns 2% interest rate which wasn’t possible if he invested in his country.
5.14: The spot price of silver is $25 per ounce. The storage costs are $0.24 per ounce per year
payable quarterly in advance. Assuming that interest rates are 5% per annum for all maturies,
calculate the futures price of silver for delivery in 9 months.

Ans:
r=.02
Rf=.01
S0=1.05
F0=1.05e(.02-.01)x2/12= 1.0518 , K<F0
Here, the actual price is lower than what should be in the future
A Swiss arbitrageur should sell Swiss franc, i.g. Fr.100, and buy dollars. The arbitrageur receives = Fr100 * 1.05 = $105
Invest this amount in a risk-free asset at 2% interest rate = 105e.02x(2/12)=105.35
Arbitrageur buys a future contract to secure the exchange rate = $1.05
At maturity, the arbitrageur converts dollars to swiss franc at the rate bought with future contract = $105.35 x (1/1.05) = 100.33
The Swiss arbitrageur earns 2% interest rate which wasn’t possible if he invested in his country.
5.15: The spot price of silver is $25 per ounce. The storage costs are $0.24 per ounce per year
payable quarterly in advance. Assuming that interest rates are 5% per annum for all maturies,
calculate the futures price of silver for delivery in 9 months.

Ans:
r=.05
S0=25
Annual storage cost per ounce = .24/6 = .06
Present value of storage cost, U = .06+.06e-.05x(3/12)+. 06e-.05x(6/12)=0.178

F0= (25+.178)e0.05x(9/12)=26.14

Future price of silver per ounce = 26.14

Ans:
Total gain or loss is the same for both future and forward contracts. However the timing of the cash flows is different. When
the time value of money is taken into account a futures contract may prove to be more valuable or less valuable than a
forward contract. The company usually doesn’t know in advance which will work out better. The long forward contract
provides a perfect edge. The long futures contract provides a slightly imperfect hedge.
a) In this case the forward contract would lead to a slightly better outcome. The company will make a loss on its hedge. If
the hedge is with a forward contract the whole of the loss will be realized at the end. If it is with a futures contract, the
loss will be realized day by day throughout the contract. One a present value basis the former is preferable.
b) In this case the futures contract would lead to slightly better outcome. The company will make a gain on the hedge. If the
hedge is with a forward contract the gain will be realized at the end. If it is with a futures contract the gain will be
realized day by day throughout the life of the contract. On a present value basis the latter is preferable.
c) Future contract would be better, because positive cash flows will be early and negative cash flows would be later.
d) Forward contract would be better because future contract would lead to early negative cashflows.
5.18: It is sometimes argued that a forward exchange rate is an unbiased predictor of the future exchange rates. Under what
circumstances is this so?

Ans: The forward exchange rate is an unbiased predictor of the future exchange rate when the exchange rate has no
systematic risk. To have no systematic risk the exchange rate must be uncorrelated with the return on the market.
5.24: What is meant by an investment asset and a consumption asset. Why is the distinction between investment and
consumption assets important in the determination of forward and future prices?

Ans:
a) Investment assets are held by significant numbers of people for pure investment purposes
b) Consumption assets are held primarily for consumption (copper, oil)

Forward/Futures price can be determined from the spot price for an investment.
Forward/futures price for the consumption assets are usually higher due to storage costs.
5.25: What is the cost of carry for:
a) a non-dividend paying stock
b)a stock index
c)a commodity with storage cost
d)a foreign currency

Ans:
a) The risk free rate
b) The excess of the risk free rate over the dividend yield
c) The risk free rate plus the storage cost
d) The excess of the domestic risk-free rate over the foreign risk free rate.
5.27:

Ans:

Here,
S0=1200
r3=.03
q3=.012
r6=.035
q6=.01
T3=3/12
T6=6/12

F3=1200e(.03-.012)*(3/12)=1205.41
F6=1200e(.035-.01)*(6/12)=1215.09
5.28: The current USA/euro exchange rate is 1.40 dollar per euro. The six month forward exchange rate is 1.3950. The size
month USD interest rate is 1% per annum. Estimate the futures price of the index for three month and six month contracts. All
interest rates and dividend yield are continuously compounded.

Ans:
Spot Exchange rate, S0=$1.40
Forward exchange rate, F0=1.3950
T=6/12=.5
r=1%

We know that,
F0=S0e(r-rf)xT
Þ 1.3950=1.40e(0.01-rf).5
Þ Ln(1.3950/1.40)=.005-0.5rf
Þ rf= .01716 or 1.716%

Six month euro interest rate is 1.716%