exercise 1

Stock BBB has a spot price equal to 80$ and a dividend equal to 10$ will be paid in 5 months. The
on year interest rate is equal to 8% (c.c).
1. Calculate the 6 month forward price?
2. Calculate the value of the contract for the short position if after 3 months the spot price of the
stock is equal to 75$, the interest rate is still at 8%

SOLUTION1
1.
I = 10 * e 0,08*0,1667 + 10 * e 0,08*0, 4167 = 19,54
F = ( S I )e r (T t ) = (80 19,54)e 0,08*0,5 = 62,93$

2.
I = 10 * e 0,08*0,1667 = 9,87
F = ( S I )e r (T t ) = (75 9,87)e 0,08*0, 25 = 66,45$
f = ( F0 F )e r (T t ) = (62,93 66,45)e 0 , 08*0 , 25 = 3,45

EXERCISE 2
A stock trades at 10$ and will pay a 0.50$ dividend in 3 months. Risk-free rate is 6% cc for all
maturities.
1) Determine the 2-month and 4-month forward prices of the stock
2) Now assume that you buy 100 stocks forward for the 4-month maturity at the price you just
determined. the stock trades at 12 $, interest rates have dropped to 4.50% and the company
has announced that the dividend will be of 1$ and not just 0.50. Determine the market value
of your deal (i.e. the original forward purchase of 100 stocks)

SOLUTION
1)
The 2-month forward is unaffected by the dividend, and is equal to:
F 2 = 10 e 0.06 / 6 = 10.1005
To calculate the 4-month forward we must take into consideration the dividend, the present value of
which has to be subtracted from today's stock price

F 4 = 10 0.50 e 0.06 / 4 e 0.06 / 3 = (10 0,4926) e 0.06 / 3 = 9,699

2)
After 1 month the 3-month forward price is

F 3 = 12 1 e 0.045 / 6 e 0.045 / 4 = (12 0,9926) e 0.045 / 4 = 11,132

The value of the purchase of 100 stock forward at t0 is:
V = 100 (11,132 9,699) e 0, 045 / 4 = 141,697

EXERCISE 3
Its December 1st 20xx. A stock trades at 400 $ and will pay a known dividend of 15$ on the 1st of
May 20xx+1. The c.c. risk-free rate is 6% for all maturities.
1) Determine the fair price of a 1-year forward contract on the stock .
2) Now assume an intermediary quoted a 1-year forward price of 415 $ . Explain how you
would build an arbitrage transaction in order to exploit the differential, if any, between
market and fair price.

SOLUTION EXERCISE 3
1)

To calculate the 6-month forward price we must take into consideration the dividend, the present
value of which has to be subtracted from today's stock price

F = 400 15 e 0.06*0.5 e 0.06 = (400 14,56 ) e 0.06 = 409.27

2)

If the forward price is 415 there is an arbitrage opportunity. Since the forward price is higher then
the spot prices the cash and carry should be applied. More specifically the strategy is : borrow 14.56
for 6 months and 385.44 for one year; buy the stock spot and sell forwards.
T=0
dividend
Borrow 4 months
Borrow 12
Buy Spot
Sell forward

+14.56
385.44
-400 + stock

T=6M

T=12M

+15
-15
409.27
+415 stock
5.73

EXERCISE 4
The two-months c.c. interest rates in Switzerland and the United States are 3% and 8%
respectively. The USD/SFR rate (number of USD for 1 SFR) is 0.65. The futures price for a
contract deliverable in 2 months is 0.66. What arbitrage opportunities does this create (assume
forward and futures prices are the same) . Show how you would build the arbitrage transaction.

SOLUTION EXERCISE 4
1)

The forward equilibrium exchange rate is

F = 0.65e (8% 3%) 2 / 12 = 0.6554

To exploit arbitrage opportunities we shoud

T=0

T=2M

Borrow USD
+100 USD
Exchange USD and -100 USD
CHF
+153.84 CHF
Invest CHF
- 153.84 CHF
BUY USD and sell
Chf at the market rate

Repay -101.34 USD

profit

1.06

Receives + 154.61 CHF

Buy +101.34 USD
Sell
-153.54

EXERCISE

A Swiss company is importing goods from the US and has to pay 500,000 USD in four months. The
companys bank offers it the following exchange rates :
Spot CHF/USD (number of CHF per one USD)
Forward 4 months CHF/USD (number of CHF per one USD)

Bid
1.32
1.29

Ask
1.33
1.31

The 4 months CHF interest rate is equal to 2.0% and the 4 months USD interest rate is equal to
5.4%.
1) Explain how the Swiss company could hedge its currency risk and how much (CHF) will
have to pay at the end of the 4 months;
2) Using the FX bid rates only, determine whether the forward FX rate is an equilibrium one or
not;
3) If the forward market rate is not an equilibrium rate, state whether the Swiss company would
be better off using this market rate or trying to get the equilibrium rate.

SOLUTION
1) The swiss company can hedge the currency risk by buying forwards dollars. At the market
forward rate of 1.31 the company will have to pay 500,000,000 USD * 1.33 chf/USD=
665,000,000CHF

2) The equilibrium rate is

3) For the company it would be better try to use the equilibrium rate. The company should
therefore borrow CHF, exchange CHF into dollars and invest in dollars

EXERCISE
A one-year-long forward contract on a non-dividend-paying stock is entered into when the stock
price is $ 40 and the risk-free rate of interest is 10% per annum with continuous compounding.
a) What are the forward price and the initial value of the forward contract?
b) Six months later, the price of the stock is $ 45 and the risk-free interest rate is still 10%. What
are the forward price and the value of the forward contract ?

Forward price = F = 40e = 44.21

Initial value is zero, like for every forward entered at market conditions
12

0 .1

Six months later we need a six-month forward

F 6 = 45e 0.10.5 = 47.31

V=

(47.31 44.21)e 0.100.5 = 2.95

EXERCISE
Suppose that you enter into a short futures contract to sell July silver for $ 5.20 per ounce on the
New York Commodity Exchange. The size of the contract is 5,000 ounces. The initial margin is
4,000$ and the maintenance margin is 3,000$. What change in the futures price will lead to a
margin call ? What happens if you do not meet the margin call ?

Value of contract = 5,000*5.20 = 26,000

Since this is a short position, in order for my balance to drop 1,000$ the value of the contract must
increase to 27,000.
This happens when the price rises to 5.40$
If the margin call is not met the position is closed out

EXERCISE
The sd of monthly changes in the spot price of live cattle is 1.2 cents per pound. The sd of monthly
changes in the futures price of live cattle for the closest contract is 1.4. The correlation between the
futures price change and the spot price change is 0.7. It is now Oct. 15. A beef producer is
committed to purchasing 200,000 pounds of live cattle on Nov. 15. The producer wants to use the
December live cattle futures contracts to hedge the risks. Each contract is for the delivery of 40,000
pounds of cattle. What strategy should the beef producer follow ?

Hedge ratio = 0.7

1.2
= 0 .6
1.4

Number of contracts =

N=

200,000 0.6
=3
40,000

EXERCISE
A company has a $ 10 million portfolio with a beta of 1.2. The S&P is currently 900 and one
futures contract is on 250 times the index. How can the company use futures contracts on the S&P
500 to completely hedge its risk over the next 6 months ? What position should it take to reduce the
beta of the portfolio to 0.3 ?

The company has a long equity position and should short the index

Number of contracts = N =

10,000,000 1.2
53
900 250

The company should short 53 contracts

If the company wants to achieve a beta of 0.3 (3/4 reduction of the original exposure) it should sell
3/4 of 53 = 40 contracts