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Chapter 5 Questions with Answers

The document discusses the determination of forward and futures prices, explaining key concepts such as forward price, value of forward contracts, convenience yield, and cost of carry. It includes several problems with calculations for forward and futures prices based on given stock prices, interest rates, and dividend yields. Additionally, it addresses arbitrage opportunities and the impact of dividends on forward contracts.

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9 views

Chapter 5 Questions with Answers

The document discusses the determination of forward and futures prices, explaining key concepts such as forward price, value of forward contracts, convenience yield, and cost of carry. It includes several problems with calculations for forward and futures prices based on given stock prices, interest rates, and dividend yields. Additionally, it addresses arbitrage opportunities and the impact of dividends on forward contracts.

Uploaded by

yousef.yousefi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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CHAPTER 5

Determination of Forward and Futures Prices


Problem 5.1.
What is the difference between the forward price and the value of a forward contract?

The forward price of an asset today is the price at which you would agree to buy or sell the
asset at a future time. The value of a forward contract is zero when you first enter into it. As
time passes the underlying asset price changes and the value of the contract may become
positive or negative.

Problem 5.2.
Suppose that you enter into a six-month forward contract on a non-dividend-paying stock when
the stock price is $30 and the risk-free interest rate (with continuous compounding) is 12% per
annum. What is the forward price?

The forward price is


30e01205 = $3186

Problem 5.3.
A stock index currently stands at 350. The risk-free interest rate is 8% per annum (with
continuous compounding) and the dividend yield on the index is 4% per annum. What should
the futures price for a four-month contract be?

The futures price is


350e(008−004)03333 = $3547

Problem 5.4.
Explain carefully the meaning of the terms convenience yield and cost of carry. What is the
relationship between futures price, spot price, convenience yield, and cost of carry?

Convenience yield measures the extent to which there are benefits obtained from ownership of
the physical asset that are not obtained by owners of long futures contracts. The cost of carry
is the interest cost plus storage cost less the income earned. The futures price, F0 , and spot
price, S 0 , are related by
F0 = S0 e( c − y )T
where c is the cost of carry, y is the convenience yield, and T is the time to maturity of the
futures contract.

Problem 5.5.
Is the futures price of a stock index greater than or less than the expected future value of the
index? Explain your answer.

The futures price of a stock index is always less than the expected future value of the index.
This follows from Section 5.14 and the fact that the index has positive systematic risk. For an
alternative argument, let  be the expected return required by investors on the index so that
E ( ST ) = S0e(  −q )T . Because   r and F0 = S0e( r −q )T , it follows that E (ST )  F0 .

Problem 5.6.
A one-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 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 are the forward price and the value of the forward contract?

a) The forward price, F0 , is given by equation (5.1) as:


F0 = 40e011 = 4421
or $44.21. The initial value of the forward contract is zero.

b) The delivery price K in the contract is $44.21. The value of the contract, f , after six
months is given by equation (5.5) as:
f = 45 − 4421e−0105
= 295
i.e., it is $2.95. The forward price is:
45e0105 = 4731
or $47.31.

Problem 5.7.
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 current value of the index is 150.
What is the six-month futures price?

Using equation (5.3) the six month futures price is


150e(007−0032)05 = 15288
or $152.88.

Problem 5.8.
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?

The theoretical futures price is


400e(010−004)412 = 40808
The actual futures price is only 405. This shows that the index futures price is too low relative
to the index. The correct arbitrage strategy is
1. Buy futures contracts
2. Short the shares underlying the index.

Problem 5.9.
A stock is expected to pay a dividend of $1 per share in two months and in five months. The
stock price is $50, and the risk-free rate of interest is 8% per annum with continuous
compounding for all maturities. An investor has just taken a short position in a six-month
forward contract on the stock.
a) What are the forward price and the initial value of the forward contract?
b) Three months later, the price of the stock is $48 and the risk-free rate of interest is
still 8% per annum. What are the forward price and the value of the short position in
the forward contract?

a) The present value, I , of the income from the security is given by:
I = 1 e−008212 + 1 e−008512 = 19540
From equation (5.2) the forward price, F0 , is given by:
F0 = (50 − 19540)e00805 = 5001
or $50.01. The initial value of the forward contract is (by design) zero. The fact that
the forward price is very close to the spot price should come as no surprise. When the
compounding frequency is ignored the dividend yield on the stock equals the risk-free
rate of interest.

b) In three months:
I = e−008212 = 09868
The delivery price, K , is 50.01. From equation (5.6) the value of the short forward
contract, f , is given by
f = −(48 − 09868 − 5001e−008312 ) = 201
and the forward price is
(48 − 09868)e008312 = 4796

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