Tutorial illustration Topic 3 Solution
Tutorial illustration Topic 3 Solution
Notation to be used
For an investment asset that provides no income and has no storage costs,
with continuous compounding:
F0 = S0e rT
If F0 > S0e rT arbitrageurs could earn a risk free profit by buying the asset and
shorting the forward;
If F0 < S0e rT arbitrageurs can sell the asset short and go long the forward to
lock in a risk free profit
Example 1:
Gold (prices in US$ per troy ounce)
Assume: S = $1720; r = 1.0%; T = 1 year
o
If r is compounded continuously:
0.01 x 1
= $1720 e
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Example 2:
Use previous data and assume the actual price of a 1 year gold futures contract is
$1,760 rather than $1,737.29.
How do you Arbitrage? 1. Sell 1 year futures now, close it out at spot
2. What is missing?
Underlying component
3. Borrow money to buy the underlying
a. Arbitrageur borrows $172,000 at 1.0% per year
b. Buys 100 ounces of gold at $1,720 per ounce
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Delivers the gold against the futures contract in 1 year and make a risk free arbitrage
profit of:
1 year time:
Today:
Sell gold at spot price
Sell 1 contract of 1 year
Buy futures at spot price to close out open position
futures today at $1,760
The expense from futures bought and proceeds from
gold sold will cancel out since the spot price is the
same
Therefore:
Today:
Net profit from arbitrage
Borrow $172,000 at 1%
Proceed from futures sold – (borrowing +interest) rate, to buy 100 ounces
returned of gold
= $176,000 - $173,729 (must take into account
for the loan interest)
= $2,271 per futures contract
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What if the spot price after 1 year was $1,750 per ounce?
1 year time:
Today:
Sell gold at spot price
Sell 1 contract of 1 year
Buy futures at spot price to close out open position
futures today at $1,760
The expense from futures bought and proceeds from
gold sold will cancel out since the spot price is the
same
1 year BUY 1,750.00 Cancel out 1 year SELL 1,750 Cancel out
Gain 10.00 Gain 30.00
Borrow $172,000 at 1%
rate, to buy 100 ounces of
Gain in short futures $1,000 gold
= $10x100ounces (must take into account
for the loan interest)
OR
Net profit from arbitrage
Proceed from futures sold – (borrowing +interest) returned
= $176,000 - $173,729
= $2,271 per futures contract
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What if the spot price after 1 year was $1,790 per ounce?
1 year time:
Today:
Sell gold at spot price
Sell 1 contract of 1 year
Buy futures at spot price to close out open position
futures today at $1,760
The expense from futures bought and proceeds from
gold sold will cancel out since the spot price is the
same
$30x100ounces
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Example 3:
What would you do if the actual futures price was only $1,710?
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Delivers the gold against the futures contract in 1 year and make a risk free arbitrage
profit of:
1 year time:
Today:
Buy gold at spot price
Buy 1 contract of 1 year
Sell futures at spot price to close out open position
futures today at $1,710
The proceed from futures sold and expense from gold
bought will cancel out since the spot price
Therefore:
Today:
Proceed from money invested (principal +interest) –
cost of futures bought Sell 100 ounces of gold
invest $172,000 at 1%
= $173,729 – $171,000 rate
= $2,279 per futures contract (Must take into account
for the investment
interest earned)
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What if the spot price after 1 year was $1,750 per ounce?
1 year time:
Today:
Buy gold at spot price
Buy 1 contract of 1 year
Sell futures at spot price to close out open position
futures today at $1,710
The proceed from futures sold and expense from gold
bought will cancel out since the spot price
1 year SELL 1,750.00 Cancel out 1 year BUY 1,750.00 Cancel out
Gain 40.00 Loss 30.00
OR
Therefore:
Proceed from money invested (principal +interest) – cost of futures bought
= $173,729 – $171,000
= $2,279 per futures contract
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What if the spot price after 1 year was $1,690 per ounce?
1 year time:
Today:
Buy gold at spot price
Buy 1 contract of 1 year
Sell futures at spot price to close out open position
futures today at $1,710
The proceed from futures sold and expense from gold
bought will cancel out since the spot price
1 year SELL 1,690.00 Cancel out 1 year BUY 1,690.00 Cancel out
Loss 20.00 Gain 30.00
OR
Therefore:
Proceed from money invested (principal +interest) – cost of futures bought
= $173,729 – $171,000
= $2,279 per futures contract
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Some investment assets provide predictable income streams to the investor,
example dividends (Share) or interest (Bonds).
F0 = (S0 – I )erT
Consider a long forward contract on a share (stock) with a current price of $40
and the risk free rate is 5% per year for all maturities, the stock pays a dividend
of $0.70 every six months the next dividend is due in 6 months.
What should the one year forward price be?
Answer:
Present Value of Dividends:
= $0.70e -0.05 x 0.5 + $0.70e -0.05 x 1
= $0.683 + $0.666 = $1.349
F0 = (S0 – I) e rT
= ($40 – $1.349)e0.05 x 1
= $40.63
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Forward price of an Investment Asset that provides a known yield
Some investment assets gives a known “yield” rather than a known cash
income; for example a share price index futures - the index can be viewed
as an investment asset paying a dividend yield (estimated)
F0 = S0e (r – q )T
Where q is the estimated dividend yield on the shares that comprise the index
during the life of the contract.
If F0 > S0e(r-q)T an arbitrageur could buy the stocks underlying the index and
sell futures.
When F0 < S0e(r-q)T an arbitrageur could buy futures and short the stocks
underlying the index.
Example:
Assume a contract on SFE’s SPI (ASX 200) futures contract with 3 months to expiry.
Suppose that:
the shares comprising the index are estimated to give a dividend yield of 4% per
annum;
the current value of the SPI is 4300; and
the continuously compounded risk free interest rate is 6% per annum
then the 3 month SPI futures price should be:
Answer:
F0 = 4300e(0.06 – 0.04) x .25
= 4321.5
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Valuing a Forward Contract
f = (F0 – K )e –rT
f = (K – F0 )e –rT
Example:
A long forward contract on an asset that provides no income was entered into some
time ago.
it currently has 4 months to maturity
the risk free rate of interest (r) is 8% per year
the current asset price (S0) is $100
the delivery price (K) is $96
= $6.53
The value of a long forward contract on an asset that provides no income can also be
expressed as:
f = S0 – Ke–rT
f = 100 – 96e -.08 x 4/12 = $6.53
(refer Hull, pp 113)
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The value of the short forward position would be
f = Ke–rT – So
= 96e -.08 x 4/12 – 100
= - $6.53
F0 = S0e (r-rf) T
Fo = Soe(r – rf)T
Fo = Soe(rf – r)T
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Example:
Assume that one year interest rates in Australia and the U.S.A. are 3.75% and 0.5%
respectively.
Assume spot exchange rate is A$1 = $US1.0450
Answer:
The one year forward rate (F0) of A$ is:
How do you Arbitrage? 1. Buy AUD Forward at 1.0015. (Lock in forward rate at
1.0015.)
2. Borrow and invest, utilising the current spot rate
Today borrow AUD and 1. Borrow AUD1,000 at 3.75% p.a. for 1 year
lock in USD rate
equivalent in 1 year Cost of borrowing , AUD1,000 * e0.0375 * 1
= AUD1,038.21
2. Lock in forward rate at 1.0015. i.e Buy AUD forward
Today, get exposure in 1. Convert borrowed AUD to USD in spot market
US market
1,000*1.0450 = USD1,045
2. Invest USD1,045 at 0.5%
1 year time Investment Grows to
USD1045 *e 0.005 *1 = USD1,050.24 in 1 year
Deliver the USD to receive AUD1051.81
1050.24 * 1.0015 = AUD1051.81 (forward rate)
Net profit from Pay back AUD borrowing cost
arbitrage
= 1051.81 – 1038.21 = 13.60
= AUD13.6
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1 year time:
Today:
Investment Grows to
USD1045 *e 0.005 *1 = USD1,050.24 in 1 year
Buy AUD Forward at
1.0015.
Deliver the USD to receive AUD1051.81
1050.24 * 1.0015 = AUD1051.81 (forward rate)
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Investment type commodities include, for example, gold and platinum, they may incur
some storage costs – this can be treated as negative income.
F0 = (S0+ U) e rT
Where U is the present value of the storage costs net of any income
Example:
Consumption Assets usually provide no income but may require significant storage
costs (e.g grains, oil)
F0 ≤ (S0+U )erT
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Impact of Cost of Carry to Investment Asset
The “cost of carry” (c) equals interest costs (r) plus storage costs (u) less
any income earned (q)
F0 = S0e cT
Where c = (r – q + u)
F0 = S0 e (c – y )T
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