Question

1. A security is currently trading at $100. The six-month forward price of this security is $104.00. It will pay a coupon of $6 in three months. The relevant interest rate is 10% p.a. (continuously compounding). No other payouts are expected in the next six months. Show the exact strategy you will use to make an arbitrage profit. State the profit and show all cash flows arising from the strategy. [6 marks]

Answer 1

first we will asses theotrical forward price

F=S*e^rt - C/e^rt

where S is spot price

r is rate per 6 months = 10%/2 = 5%

c is coupon payment

F = 100e^(0.05) - 6/e^(0.025) = 99.275

but actual futures price is 104

so arbitration exixts

so profits are 104-99.275 = 4.725

process of arbitration

1) short sell in forward market at 104

2) long security trading at 100 in spot market

3)after 6 months settle the futures contract

cash flows

	cashflows
actions	now	3 months	6 months
short forward			104
long spot market	-100
coupon		6

hope you understood anydoubts please comment