Question

You want to short a 6-month forward contract on a stock. You contacted your bank and were offered a forward price of $39.85 [Note: This forward price is available only to customers who want to take a short position. Customers who want to take a long position will get a different quote.]. You also observe the following information:

Current price of the stock = $40

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Expected dividend on the stock = $0.50, payable 3 months from now

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Your spot 3-month lending rate = 2.50% p.a. [i.e., This is the rate that you will

get if you lend money for 3 months, starting now.]

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Your spot 3-month borrowing rate = 4.00% p.a. [i.e., This is the rate that you

will have to pay if you borrow money for 3 months, starting now.]

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Your transaction cost in buying one stock in the spot market = $0.10, payable at the time of the transaction.

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Your transaction cost in short selling one stock in the spot market = $0.20, payable at the time of the transaction (This already includes the transaction cost for closing out the short-sale transaction).

3

What is the minimum 6-month spot lending rate that you need to get in order for you to reject the bank's offer?

Answer 1

a)

The minimum 6- month spot lending rate that required to reject the bank offer.

Current price	$40
Less Transaction cost	$0.20
Less:Expected dividend	$0.50
Net receiving after selling in spot market	$39.3
Forward price	$39.85
Difference	$0.55
Lending intereset required to reject the bank offer
minimum lending interest rate required	1.40% p.a

If we sell the in spot market at price $40 with trasaction cost and opportunity cost of dividend $0.50, The lending rate at which we can reach the bank forward rate of $39.85 is 1.40%

so we can reject the bank offer at minimum 6 month  lending interest rate of 1.40% p.a