ECON 372 in Winter 2010

Suggested Answers to Assignment 1

Q1. Question 1.27 (page 20 in the textbook): On September 12, 2006, an investor
owns 100 Intel shares. As indicated in Table 1.2 (Slide 22 of Chapter 1) the
share price is $19.56 and a January put option with a strike price of $17.50
costs $0.475. The investor is comparing two alternatives to limit downside
risk. The first involves buying one January put option (American) contract
with a strike price of $17.50. The second involves instructing a broker to sell
the 100 shares as soon as Intel’s price reaches $17.50. Discuss the advantages
and disadvantages of the two strategies. (HINT: consider the following two
scenarios: Intel share price goes all the way down and Intel price goes down
and up.)

An: The second alternative involves what is known as a stop or stop-less order. It
costs nothing and ensures that $1,750, or close to $1,750, is realized for the
holding in the event the stock price ever falls to $17.50. The put option costs
$47.50 and guarantees that the holding can be sold for $1,750 any time up to
January. If the stock price falls marginally below $17.50 and then rises the
option will not be exercised, but the stop-less order will lead to the holding
being liquidated. There are some circumstances where the put option alter-
native leads to a better outcome and some circumstances where the stop-less
order alternative leads to a better outcome because of the cost of the option is
avoided. If the stock price falls to $17.00 in November and then rises to $30 by
January, the put option alternative leads to a better outcome. The investor is
paying $47.50 for the chance to benefit from this second type of outcome.

Q2. A company enters into a short futures contact to sell 200 ounces of platinum
for $1,200 per ounce. One futures contract is on 50 ounces of platinum. The
initial margin per contract is $2,700 and the maintenance margin is $2,000.
What price change would lead to a margin call? Under what circumstances
could $4, 000 be withdrawn from the margin account?

An: There is a margin call if $700 is lost on one contract. This will happen if
the price of platinum futures rises by $14 to $1,214 per ounce. $4,000 can be
withdrawn if the futures price falls by $20 to $1,180 per ounce.

Q3. The spot price of an investment asset is $30 and the risk-free rate for all ma-
turities is 10% p.a. This asset provides an income of $2 at the end of the first
and at the end of the second year. Consider a three-year forward contract:

1
 a). If the forward price is $37, are there arbitrage opportunities? If so, how
would you arbitrage? Show the cash flows of how you would arbitrage.
b). If the forward price is $34, are there arbitrage opportunities? If so, how
would you arbitrage? Show the cash flows of how you would arbitrage.
c). What should be the “fair” forward price?

An: a). If the forward price is $37, there are arbitrage opportunities. Borrow
$1.8097, $1.6375, and $26.5528 @ 10% for 1, 2, and 3 years. Use the
borrowed money to buy one unit of asset @ $30. Take a short position of
a forward contract to sell one share in 3 years for $37.
Trade CF now CF in 1 yr CF in 2 yrs CF in 3 yrs
Borrow $1.8097 @ 10% for 1 yr +1.8097 -2 0 0
Borrow $1.6375 @ 10% for 2 yrs +1.6375 0 -2 0
Borrow $26.5528 @ 10% for 3 yrs +26.5528 0 0 35.8425
Buy 1 unit of asset -30 0 0 S1
Income 0 +2 +2 0
Short forward 0 0 0 37 − S1
0 0 0 37 − 35.8425

So there is a riskless profit of 1.1575 per unit of asset.

b). If the forward price is $34, there are arbitrage opportunities. Short sell
one unit of asset. Invest $1.8097, $1.6375, and $26.5528 @ 10% for 1, 2
and 3 years, respectively. Take a long position of a forward contract to
buy one unit of asset share in 3 years at $34.
Trade CF now CF in 1 yr CF in 2 yrs CF in 3 yrs
Short sell 1 unit of asset +30 0 0 −S1
income 0 -2 -2 0
Invest $1.8097 @ 10% for 1 yr -1.8097 +2 0 0
Invest $1.6375 @ 10% for 2 yrs -1.6375 0 +2 0
Invest $26.5528 @ 10% for 3 yrs -26.5528 0 0 35.8425
Long forward 0 0 0 S1 − 34
0 0 0 35.8425-34
So there is a riskless profit of 1.8425 per unit of asset.
c). The fair forward price should be $35.84.

Q4. Consider an investment asset that provides a yield of 5% quarterly compound-

ing. The current price of this asset is $40 and the risk-free interest rate is 7.5%
p.a. For the one-year forward contract on this asset:

a). What is the theoretical forward price?

b). If the forward price is $40.50, write down carefully how you would take
advantage of this forward price.

2
 c). If the forward price is $41.80, write down carefully how you would take
advantage of this forward price.

An: a). The average yield is

 
5%
q = 4 × ln 1 + = 4.9690%.
4

So the forward price is 40 × e0.075−0.04969 = 41.0253.

b). The forward price of $40.50 is undervalued. Therefore, we do the following
to arbitrage:
∗ Short sell e−4.9690% units of the asset at

$40 × e−4.9690% = $38.0610

∗ Invest the proceeds at 7.5%

∗ Long one forward contract to buy one unit of the asset at $40.50
At maturity, your investment grows to $38.0610×e7.5% = $41.0253. There-
fore there is a riskless profit of 41.0253 − 40.50 = $0.5253
c). The forward price of $41.80 is overvalued. Therefore, we do the following
to arbitrage:
∗ Borrow money at 7.5% to buy e−4.9690% units of the asset at

$40 × e−4.9690% = $38.0610

∗ Short one forward contract to sell one unit of the asset at $41.80
At maturity, you pay back the loan $38.0610×e7.5% = $41.0253. Therefore
there is a riskless profit of 41.80 − 41.0253 = $0.7747

Q5. Suppose that the risk-free interest rate is 8% p.a. and that the dividend yield on
a stock index is 4% p.a. The current value of the index is 1, 300. An investor
has just taken a short position in a four-month forward contract on the stock
index.

a). What are the forward price and the initial value of the forward contract?
b). Two months later, the value of the index is 1, 245 and the risk-free rate of
interest changes to 7% p.a. What are the forward price and the value of
the short position in the forward contract this investor has taken?
4
An: a). The average dividend yield is 4%. So the forward price is 1300e(0.08−0.04)× 12 =
1317.4494. The initial value of the forward contract is (by design) zero.

3
b). In two months, the forward price is

1245e(0.07−0.04)×2/12 = 1251.2406

The delivery price, K, is 1317.4494. The value of the short forward con-
tract, f , is given by
2
f = (1317.4494 − 1251.2406)e−0.07× 12 = 65.44