INDIVIDUAL ASSIGNMENT

Financial Derivatives and Risk Management

(FDRM)

TOPIC: Individual Assignment

1. Consider a 3-month futures contract on an index. Suppose that the stocks underlying the index
provide a dividend yield of 1% per annum, that the current value of the index is 1,300 and, that
the continuously compounded risk-free interest rate is 5% per annum. Calculate the futures
price?

𝐹0= ?
𝐹0 = 𝑃0 𝑒(𝑟−𝑞)𝑡
𝑃0= 1300
𝑡 = 3/12 months 3
(0.05−0.01)
𝑞 = 1% 𝐹0 = 1300 ∗ 𝑒 12

𝑟 = 5% 𝐹0 = 1313.065

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2. Sivam securities will need to purchase a security in 75 days. It expects the security prices to rise
by that time, so it decides to hedge this risk by buying the security forward. The spot price of
the asset is Rs.5,000 if the interest rate is 7.5%p.a.(A/360). Calculate the price of 75 day and 90
days forward for the security. Which contract should it use for its purpose?

𝐹0 = 𝑃0 𝑒𝑟𝑡

𝐹0 = ?
𝑃0 = Rs. 5000/-
𝑡1 = 75 days
𝑡2 = 90 days
𝑟 = 7.5%
a. 𝐹0 = 5000 ∗ 𝑒(0.075)(75/360)
𝐹0 = 5078.739

b. 𝐹0 = 5000 ∗ 𝑒(0.075)(90/360) =>

𝐹0 = 5094.634
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3. Calculate the price of a 6 month forward contract on an asset that is expected to provide
income equal to 3.96% per annum with continuous compounding. The risk-free rate of interest
per annum is 10%. The asset price is Rs. 25

𝐹0 = 𝑃0 𝑒(𝑟−𝑖)𝑡
𝐹0 = ?
𝑃0 = 25
𝑖 = 3.96%
𝑟 = 10%
𝑡 = 6 months
𝐹0 = 25 𝑒(0.1−0.0396)0.5
𝐹0 = 25.7665

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4. Assume the spot price of a non-dividend paying stock as Rs. 1,400 and the carrying cost is 12%.
What is the fair price of a one year forward contract? Using arbitrage argument establish the
forward price.

Answer: If the spot price for the stock is Rs. 1400 and the carrying cos is 12% (1400 * 0.12 = Rs.
168), then the forward contract price should be more than 1568 (1400 + 168) for an arbitrageur
to make money. So, the fair value should be greater than the total of spot price and its related
carrying cost. (Fair value > spot price + carrying cost)

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5. Suppose that the risk-free interest rate is 10% per annum with continuous compounding and
that the dividend yield on a stock index is 4% per annum. The index is standing at 400, and the
futures price for contract deliverable in 4 months is 405. What arbitrage opportunity does this
create?

𝐹0 = 𝑃0 𝑒(𝑟−𝑞)𝑡
405 = 400 𝑒(0.1−0.04)4/12 => 405 < 413.18
 Comment: Since the future price is less than the spot price plus carrying cost (405 > 413.18), this
doesn’t create any arbitrage opportunity for an arbitrageur. If he carries the asset till expiration
date, he will face a loss of 8.18 (413.18 – 405)

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6. The 2-month interest rates in Switzerland and the United States are 2% and 5% respectively.
With continuous compounding. The spot price of the Swiss Franc is $0.80. The futures price for
a contract deliverable in 2 months is $0.81. What arbitrage opportunity does this create?

𝐹0 = 𝑃0 𝑒(𝑟−𝑟𝑓)𝑡
0.81 = 0.80 𝑒(0.05−0.02)2/12 => 0.81 > 0.8040

Comment: Since the future price is greater than the spot price plus carrying cost, there is an
arbitrage opportunity for arbitrageurs to take a long position in spot market and a short
position in future market. He or she will pocket the spread (0.81 – 0.8040 = 0.006)

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