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Homework 4
FNCE 745
1. Let the spot price of oil on Jan 1st 2010 be $100 per barrel. Suppose the
6-month forward price is $98. Assume that the storage cost of a barrel of
oil is 2% at an annual rate compounded continuously (paid upfront). What
is the profit/loss earned on a cash-and-carry transaction entered on Jan 1st
2010 and closed at the end of June 2010. The annualized interest rate is 5%.
Assume that there is no lease market for oil.
Answer: We can calculate the profit in two ways: Firstly, it can be written
as
Profit = F0 S0 e(r+u)T = 98 100 e.070.5 = 5.5619.
Another way to calculate it is to first calculate the lease rate. We have
=r

1
ln(F/S) = 0.05 1/(0.5)ln(98/100) = 0.0904.
T

Then, we can calculate

Profit = S0 er T e.09040.5 e0.020.5 = 5.5619.
2. Question 6.5.
(a) The spot price of gold is $300.00 per ounce. With a continuously compounded annual risk-free rate of 5%, and at a one-year forward price
of 310.686, we can calculate the lease rate according to the formula:




F0,T
310.686
1
= 0.05 ln
= 0.015
l = r ln
T
S0
300
(b) Suppose gold cannot be loaned. Then our cash and carry arbitrage
is:
Transaction
Short forward
Buy gold
Borrow @ 0.05
Total

Time 0
0
$300
$300
0

Time T = 1
310.686 ST
ST
$315.38
4.6953

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The forward price bears an implicit lease rate. Therefore, if we try to
engage in a cash and carry arbitrage, but if we do not have access to
the gold loan market, and thus to the additional revenue on our long
gold position, it is not possible for us to replicate the forward price.
We incur a financial loss. The financial loss however, usually offset by
the conveience of holding the commodity.
It is useful to note that in the class notes, we did a similar problem for
oil, where there is a positive storage cost. Here, we assume that the
storage cost of gold is zero. Using the formula in the notes, we would
have profit = F0 S0 e(r+u)T = 310.686 300e.05 = 4.6953, as in
the above table.
(c) If gold can be loaned, we engage in the following cash and carry arbitrage:
Transaction
Short forward
Buy tailed gold
position, lend @ 0.015
Borrow @ 0.05
Total

Time 0
0
$295.5336

Time T = 1
310.686 ST
ST

$295.5336
0

$310.686
0

Therefore, we now just break even: Since the forward was fairly priced,
taking the implicit lease rate into account, this result should not surprise us.
Some notes on the line buy tailed gold. It just means to buy less
units today to take into account the income from leasing. In the notes
we broke this up into two terms: the first was the cash needed for
purchasing the commodity, and the second was the income received
from leasing. Adding up gives the cash required for the tailed position.
3. Question 6.6.
(a) The forward prices reflect a market for widgets in which seasonality is
important. Let us look at two examples, one with constant demand and
seasonal supply, and another one with constant supply and seasonal
demand.
One possible explanation might be that widgets are extremely difficult
to produce and that they need one key ingredient that is only available

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during July/August. However, the demand for the widget is constant
throughout the year. In order to be able to sell the widgets throughout
the year, widgets must be stored after production in August. The forward curve reflects the ever increasing storage costs of widgets until
the next production cycle arrives. Once produced, widget prices fall
again to the spot price.
Another story that is consistent with the observed prices of widgets
is that widgets are in particularly high demand during the summer
months. The storage of widgets may be costly, which means that widget producers are reluctant to build up inventory long before the summer. Storage occurs slowly over the winter months and inventories
build up sharply just before the highest demand during the summer
months. The forward prices reflect those storage cycle costs.
(b) IMPORTANT TERMINOLOGY: This question asks for the rate of
return on a cash-and-carry. This is actually cannot be calculated,
since the up front investment in such a strategy is 0. Instead, we can
calculate the rate of return on a carry stategy, where the purchase of
the commodity is done by the resources of the arbitrager.
Let us take the December 2004 forward price as a proxy for the spot
price in December 2004. We can then calculate with our carry arbitrage tableau:
Transaction
Short March forward
Buy December
Forward (= Buy spot)
Pay storage cost
Total

Time 0
0
3.00

Time T = 3/12
3.075 ST
ST

3.00

0.03
3.045

We can calculate the annualized rate of return as:

3.045
= eT
3.00


3.045
ln
= 3/12
3.00
= 0.05955
which is close to the prevailing risk-free interest rate of 0.06. Had the

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forward price been given as 3.07534 = 3 exp(.06 3/12) + .03, the
return would have been exactly the riskless rate.
(c) Let us again take the December 2004 forward price as a proxy for the
spot price in December 2004. We can then calculate with our carry
arbitrage tableau:
Transaction
Short Sep forward
Buy spot
Pay storage cost Sep
FV(Storage Jun)
FV(Storage Mar)
Total

Time 0 Time T= 9/12

0
2.75 ST
3.00 ST
0.03
0.0305
0.0309
3.00 2.6586

We can calculate the annualized rate of return as:



2.6586
2.6586
()T
=e
ln
= 9/12
3.00
3.00
= 0.16108
This result may seem surprising. We would earn a negative annualized
return of 16% on such a cash and carry arbitrage. This is because
there is a positive convenience yield attached to widgets for this time
span, and the loss reflects the benefit of holding the commodity. If the
commodity could be leased, then as shown in class, there would no
profit or loss.
4. Question 6.7
(a) Lets back out the lease rate from the forward price. We have to adjust
the formula for forwards in the class notes just a bit to take into account the discrete form of the storage costs. Now we have the forward
pricing formula:
F0 = S0 e(ry)t + Future Value of Storage Costs
. Note the difference from the equation in the class notes: F0 = S0
e(r)t , where = y u. Here, the storage cost is written separately,
so, only the convenience yield is subtracted from the riskless rate in
the exponentiated term.

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Back to our problem: For the 3-month forward contract we then have
3.075 = 3 e(0.06y)0.25 + 0.03.
Therefore y = 0.06 4 ln(3.045/3) = 0.00045, which is very close to
zero. The holder of the commodity does not benefit very much from
holding it, so will play close to zero. Instead, the borrower of the
commodity will ask for the 0.03 of compensation for the storage cost.
So, overall, the borrower of the commodity receives some funds for
holding the commodity.
(b) Using the same formula as above, now we solve:
2.75 = 3 e(0.06y)0.75 + 0.03(e.060.5 + e.060.25 + 1).
Note, that we need the future value of the storage costs, which are all
payable at the end of each quarter. So the future value of the first cost
is compounded with two quarters of interest, the second cost for one
quarter, and the last cost is paid at the third quarter so no need to adjustment for future value. Solving the equation, we get y = 0.221068.
So, the payment from the borrower to the lender should be convenience - costs of storage = 3 (e.2210680.75 1) 0.091367 = 0.44964.