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F = S + CC – CR
where:
• Today
borrow +S
buy the good -S
sell the good forward ___
CF0 = 0
• At delivery
repay loan w/ interest -S(1+h(0,T))
sell at forward price +F
CFT = F-S(1+h(0,T)) > 0 ARBITRAGE PROFIT!
©David Dubofsky and 5-2
Thomas W. Miller, Jr.
Forward Pricing:
Cash and Carry Arbitrage
• h(0,T) = the unannualized interest rate = rT/365
– T = days until delivery
– r = the annual interest rate
• If the set of cash and carry trades entails no cash flow at time 0, there
must be no cash flow at time T (delivery).
• If F-S(1+h(0,T)) >0, then by borrowing to buy the spot good, and selling
it forward, you can arbitrage.
• Today
sell the good +S
lend the proceeds -S
buy the good forward ___
CF0 = 0
• At delivery
the loan repays you w/ interest +S(1+h(0,T))
buy at forward price -F
CFT = -F+S(1+h(0,T)) > 0 ARBITRAGE!
• Spot gold sells for $403/oz. The six month interest rate is 4.5%;
the one year interest rate is 5% (both are annual rates).
• The forward price of gold for delivery one year hence must be:
403(1.05) = 423.15.
aaAccrual_days
effective date 23-Sep-97
terminating date 22-Mar-98
accrual method 2 actual/ 360
actual/ 360
• What if the actual forward price of gold for delivery 6 months hence is
413? [that is, FP0 > S(1+h(0,T))]
• What if the forward price of gold for delivery one year hence is
422? [that is, FP0 < S(1+h(0,T))]
• At delivery
repay loan w/ interest ($41.20)1 -S(1+h)
receive divs w/ interest ($0.6105)2 +FV(divs)
sell good at forward price __ +F____
CFT = F-S(1+h)+FV(divs)
T
FV(Divs) Div (1 h(t, T))
t0 t
t_14
dividend payment table
all the dividend dates from the value date
dividend
to the
amount
expiry date
23-Oct-97 0.3
23-Jan-98 0.3
F0 S0
h(0,T) IRR
S0
F0 CR S 0
h(0, T) IRR
S0
• That is, futures prices can be below their cost of carry theoretical
price, and no reverse cash and carry arbitrage will occur.
• Today:
borrow $0.00947 to buy one unit of fx +S
buy one unit of fx -S +1FX
lend the one unit of fx -1FX
sell (1)(1+hf) forward ___________________
CF0 = 0 0
aaFXfwd
FX spot - domestic / foreign 0.00947
rate - domestic - annual 0.05
rate - foreign - annual 0.015
value (settlement) date 23-Sep-97
forward delivery or repurchase date 23-Mar-98
accrual method - domestic rate 4 30/ 360
30/ 360
accrual method - foreign rate 4 30/ 360
30/ 360
statistic 2 fair
fair value offorward
value of forward(domestic
(domestic / foreign)
/ foreign)
• Let r(0,t2) = the annual spot interest rate for the period ending at the
end of the contract period (e.g., in a 1X7 FRA, this would be the 7-
month rate).
• Let r(0,t1) = the annual spot interest rate for the period ending at the
settlement date (e.g., the 1-month rate in a 1X7 FRA).
• The forward rate is r(t1,t2). It is the six month rate, beginning one
month hence. This is the contract rate of a FRA.
• So, if the 7-month rate is 6%, and the 1-month rate is 4.5%, then the six
month forward rate, beginning one month hence, is computed as:
t_43_1
discount factor curve
grid date discount factor
23-Sep-97 1
23-Oct-97 0.996338645
23-Apr-98 0.966580981
Lend
Borrow Borrow
0 t1 t2 0 t1 t2
• These are reverse cash and carry trades: sell the deliverable
asset short and lend the proceeds until the delivery date.
Borrow
Lend Lend
0 t1 t2 0 t1 t2
• These are cash and carry trades: borrow to buy the deliverable
asset.
• Today:
– borrow $0.99626401 for one month at r(0,1) = 4.5%
– lend $0.99626401 for seven months at r(0,7) = 6% (buy a seven month
debt instrument)
• Exploits the fact that the same asset has a different price in
different markets.
• A true arbitrage:
– Zero Investment
– Zero Risk
– Positive Return.
• Arbitrageur or Arbitrageuse?
• Today:
• Note Bene:
• Today: