Question

An assumption is made that you own a security currently worth K500. You plan to sell it in two months. To hedge against a possible decline in price during the next two months, you enter into a forward contract to sell the security in two months. The risk – free is 3.5%.

a. Calculate the forward price on this contract

b. Suppose the dealer offers to enter into forward contract at K498. Indicate how you could earn an arbitrage profit.

c. After one month, the security sells for K490. Calculate the gain or loss to your position.

Answer 1

a. Forwrd Price of the Contract =Future Value of Current Price

Risk Free Interest rate for two months=3.5%*(2/12)=0.58333%

Forward Price =500*1.0058333=K502.92

b. If Forward Contract Price =K498

Steps for arbitrage profit:

1.Buy at K498 in forward

2. Borrow one security and sell at current price =K500

3. Invest K500 at risk free rate of 3.5%

4. After two months you get K502.92 from investment with interest

5. Pay K498 and get one security as per forward contract

6. Return the borrowed security along with interest

c. After one month if price =K490, unrealized loss=498-490=K8