Problem Set I: Derivatives in Investment Management

Course 643, Fall 2016

Course Instructor: Irina Zviadadze
Stockholm School of Economics

This homework is designed to understand properties and pricing of forwards and futures.
This assignment is worth 5% of your final grade. To receive full credit, you are required to
show your work, e.g., outline your logic and provide computations. Assignments must be
submitted on September 12th, before class starts. Late submissions are not permitted and
result in zero credit. Assignments are completed in group of four students. Indicate your
names on the front page.
1. Futures on a dividend yield index, 1 point:
Suppose the annual continuously compounded risk-free rate is r = 5%. The annual
dividend yield on S&P 500 is q = 2%. The current index level is S = 1400, and the
futures price for a contract deliverable in four months is F = 1420.
(a) Show that there is an arbitrage opportunity.
(b) Describe exactly how you would implement a strategy to profit from mispricing.
What units of each security would you buy/sell and when? Calculate the net cash-flows
at inception and at maturity.
2. Forward pricing & frictions, 0.5 points:
Spot price of stock ABC is $100. The forward price of the same stock to be delivered
in one year is $110. Borrowing market rate is 6% per year and lending market rate is
4% per year. Is there arbitrage opportunity here? If so, please describe the trade that
earns arbitrage profit. Consider annual compounding for interest rates.
3. Margin calls and liquidity risk, 1 points:
A futures trader initiates a short position in 10 contracts in gold at a futures price
of $276.50 per oz. The size of one futures contract is 100 oz. The initial margin per
contract is $1,500, and the maintenance margin per contract is $1,100.
(a) What is the initial size of the margin account?
(b) Suppose that the trader has access to as much liquidity as he desires to satisfy any
margin calls. Ignore any interest rate effects (rate of interest is zero for simplicity).
Suppose the futures settlement price on the next ten days is
1

$278.00 per oz.

$281.00 per oz.
$285.00 per oz.
$282.50 per oz.
$277.25 per oz.
$273.00 per oz.
$275.75 per oz.
$279.00 per oz.
$277.50 per oz.
$276.00 per oz.
What is the balance in the margin account at the end of each day? On which days
does a margin call occur? Assume that when a margin call occurs, the account is
topped back to its original level (the initial size of the margin account). What are
the traders total gains or losses on the tenth day when he closes out his position?
(c) Assume now that the trader is limited in his access to liquidity to a line of credit
of size $X. Interest costs are again zero. Let X take on the values 2,500 and
5,000. For each value of X, repeat the above exercise: What is the balance in the
margin account at the end of each day? On which days does a margin call occur?
Assume that when a margin call occurs, the account is topped back to its original
level if there is sufficient liquidity. Every margin call draws down the available
amount in the line of credit. If there is insufficient liquidity to top the margin
account back to its original level, the entire available liquidity is put into the
margin account. If the available liquidity does not meet the maintenance margin,
there is a liquidity default. When does the trader face a liquidity default, if any,
for different values of X?
4. Forward prices, 1 point:
You go long a one-year forward contract on oil when the spot price is $75 and the
annual continuously compounded risk free rate is 5%. Assume oil can be borrowed
and/or stored costlessly.
(a) What are the forward price and the initial value of your forward contract?
(b) Six months after the signing of this contract, the spot price is $85 and the risk-free
interest rate is still 5%. What is the forward price on your contract now? What
is the value of your contract?

5. Forward Pricing, Arbitrage, and Transaction Costs, 1.5 points: You are working at a
hedge fund and your recently developed Arbitrage-Finder computer system that has
identified an arbitrage opportunity involving MBC stock and its 6-month forward contract. The stock is currently traded for $94.95 and the 6-month forward price is $96.58.
The annual continuously compounded risk free rate is 5.4%. Assume markets are frictionless (no transaction costs, bid-ask spreads, etc.) and that you believe the stock
will not pay any dividends.
(a) How would you take advantage of the arbitrage opportunity? Make the initial
investment zero and find the future certain profits for a position using 1 stock and
1 forward.
(b) Your broker informs you that there is in fact a spread of 20bp between available
borrowing and lending rates: You can lend at 5.3% and borrow at 5.5%. Taking
this into account, what is the no-arbitrage range of the forward price? Can you
still profit from the arbitrage opportunity?
(c) You just learned that MBC is in fact scheduled to pay a $5 dividend per stock
in three months. The annual continuously compounded risk free rate is 5.5% for
both lending and borrowing. Now, what is the no-arbitrage forward price? Can
you make certain arbitrage profits? If so, please provide details.

Good luck!