Question

Suppose we observe the following: Current spot or cash price = $100 Interest rate (both borrowing...

Suppose we observe the following:

Current spot or cash price = $100

Interest rate (both borrowing and lending) = 8% (continuous rate)

Dividend rate on asset = 2% (continuous rate)

No transaction costs and the asset can be both costlessly stored and sold short.

1. Suppose the price of one year forward contracts is $110. Explain how you could construct a riskless arbitrage and calculate the profits.

2. Suppose the price of one year forward contracts is $100. Explain how you could construct a riskless arbitrage and calculate the profits.

3. Given the results in 1 and 2, what can we say about what the price of one year forward contracts should be if the spot price is $100? Explain.

Homework Answers

Answer #1

(1)

(2)   

Know the answer?
Your Answer:

Post as a guest

Your Name:

What's your source?

Earn Coins

Coins can be redeemed for fabulous gifts.

Not the answer you're looking for?
Ask your own homework help question
Similar Questions
Suppose that the current spot price of a continually paying dividend asset is $222, the interest...
Suppose that the current spot price of a continually paying dividend asset is $222, the interest rate is r = 3% and the dividend yield is q = 2%. (a) What are the one-month and eight-month forward prices for the asset in an arbitrage-free market? (b) Let X be a portfolio on time interval [0, T] consisting of three positions startng from time 0: borrow $222 at the rate 3%, long 1 unit of the asset, and short the three-month...
3. You observe that the current spot price of gold is TL400 per ounce. You also...
3. You observe that the current spot price of gold is TL400 per ounce. You also observe that the yield curve is flat and all maturities up to one year have an interest rate of 12 percent. Since gold is a popular underlying asset in the derivatives markets, you are interested in identifying any mispricing that may allow you to earn arbitrage profits. When you look up gold forward contract prices, you see that there is a contract with a...
You observe the following market interest rates, for both borrowing and lending: One-year rate = 5%...
You observe the following market interest rates, for both borrowing and lending: One-year rate = 5% two-year rate = 6% one-year rate one year from now = 7.25% How can you take advantage of these rates to earn a riskless profit? Assume that the Pure Expectation Theory for interest rates holds. 2. “If bonds of different maturities are close substitutes, their interest rates are more likely to move together.” Is this statement true, false, or uncertain? Explain your answer.
The current continuously compounded risk free interest rate is 4% and we observe today, in May,...
The current continuously compounded risk free interest rate is 4% and we observe today, in May, that the November six months futures price for gold is £1,200. The one year May futures price for gold is £1,020. Is there an arbitrage opportunity? Demonstrate how we can exploit this arbitrage opportunity (No need to calculate the profits).
The S&R index spot price is 1100, the continuously compounded risk-free rate is 5%, and the...
The S&R index spot price is 1100, the continuously compounded risk-free rate is 5%, and the continuous dividend yield on the index is 2%. (a) Suppose you observe a 6-month forward price of 1120. What arbitrage would you undertake? (b) Suppose you observe a 6-month forward price of 1110. What arbitrage would you undertake? *YOU MUST ANSWER WITH DETAILED WORKING!!
You observe the following market interest rates, for both borrowing and lending: One-year rate = 5%...
You observe the following market interest rates, for both borrowing and lending: One-year rate = 5% Two-year rate = 6% One-year rate one year from now = 7.25% Suppose you borrow $100 for two years, lend the proceeds for one year, and then lend the total interest and principal received for 1 year at the start of year 2 for one year. What is your gain to the nearest cent?
You observe that the EUR/HKD spot exchange rate (i.e., the price of 1 Euro in terms...
You observe that the EUR/HKD spot exchange rate (i.e., the price of 1 Euro in terms of Hong Kong Dollars) is 8.91 and the 1-year EUR/HKD forward exchange rate is quoted at 9.5.(Total 10 marks) (a) Does an arbitrage opportunity exist given that the 1-year deposit rates in Hong Kong and Europe and are 2.5% and 0.5%, respectively? (b) If so, outline an arbitrage strategy and explain step by step why your strategy yields risk-free profits.
Suppose you observe that 90–day interest rate across the eurozone is 5%, while the interest rate...
Suppose you observe that 90–day interest rate across the eurozone is 5%, while the interest rate in the U.S. over the same time period is 3%. Further, the spot rate and the 90–day forward rate on the euro are both $1.25. You have $500,000 that you wish to use in order to engage in covered interest arbitrage. Which of the following best describes covered interest arbitrage? a)Using forward contracts to mitigate default risk, while attempting to capitalize on equal interest...
The S&R index spot price is 1100, the continuously compounded interest rate is 5%, and the...
The S&R index spot price is 1100, the continuously compounded interest rate is 5%, and the dividend yield on the index is 2%. (Round your answers to two digits after the decimal point when rounding is necessary) (A)What is the fair forward price for a 6-month forward? (B)Suppose you observe a 6-month forward price of 1120, and you decide to perform an arbitrage strategy. Illustrate the transactions you will undertake and the amount of profit you will make from this...
Covered Interest Arbitrage. Assume the following information: • British pound spot rate = $1.65. • British...
Covered Interest Arbitrage. Assume the following information: • British pound spot rate = $1.65. • British pound one-year forward rate = $1.65 • British one-year interest rate = 12 %. • U.S. one-year interest rate = 10 %. Explain how U.S. investors could use covered interest arbitrage to lock in a higher yield than 9 percent. What would be their yield? Explain how the spot and forward rates of the pound would change as covered interest arbitrage occurs.