Question

a 3 month forward contract on a non-dividend paying asset is trading at 90 and spot price is 87.

a) calculate the implied risk free rate.

b) you can borrow at 13% pa cont. compounded for hree months . list the step to be taken to exploit this situation.

c) compute the risk free profit in part b

Answer 1

Answer-(a)

For a non dividend paying stock,

F = Forward price

S = Spot price

r = implied risk free rate per annum

t = time

e= 2.7182818

hence here,

=> r or risk free rate = 13.561% per annum.

(b)

As you are getting the loan at cheaper rate, hence follow the following steps to earn risk free arbitrage profit-

Step-1	Borrow 87 @13% for 3 months and buy the asset for 87.
Step-2	Enter into forward contract to sell the sell@90 after 3 month
step-3	After 3 month amount to be paid for loan obtained	89.87
	[87* e^(13%*3/12)]
Step-4	sell theasset as per the Forward contract and receive 90	90
Step-5	Arbitrage profit or risk free profit after 3 month	0.13
	[receive 90- pay 89.87]

(c)

risk free profit = 0.13 per contract.