Solutions to Homework 4

FM 5021 Mathematical Theory Applied to Finance

4.15 Use the rates in Problem 4.14 (given in the table below) to value an
FRA where you will pay 5% for the third year on $1 million.
Maturity (years) Rate (% per annum)
1 2.0
2 3.0
3 3.7
4 4.2
5 4.5
The forward interest rate for the third year with continuous compounding is
0.037(3) 0.03(2)
3 2
= 0.051, i.e. 5.1%,
which measured with annual compounding is equal to
e
0.051
1 = 0.05232 or 5.232%.
Since the 3-year interest rate is 3.7% with continuous compounding, the value of the FRA
is
1, 000, 000 (0.05232 0.05) 1 e
0.0373
= $2, 078.85.
4.16 A 10-year 8% coupon bond currently sells for $90. A 10-year 4% coupon
bond currently sells for $80. What is the 10-year zero rate? (Hint: Consider
taking a long position in two of the 4% coupon bonds and a short position in
one of the 8% coupon bonds.)
A long position in two 4% coupon bonds and a short position in one 8% coupon bond lead
to a cash ow of $90 2 $80 = $70 in year 0 and a cash ow of $200 $100 = $100
in year 10. Since the coupons cancel out, $100 in 10 years is equivalent to $70 today.
Therefore, the 10-year rate with continuous compounding satises
100 = 70e
10R
.
Hence, R =
1
10
ln
100
70
= 0.0357, i.e. 3.57% per annum.
5.2 What is the dierence between the forward price and the value of a
forward contract?
The forward price of an asset is the price at which you would agree to buy or sell the asset
at a future time. The value of a forward contract is zero at the time when it is rst entered
1
into. As time passes, the underlying asset price changes, and the value of the contract may
become positive or negative.
Consider, for example, a forward contract on an investment asset with price S
0
that provides
no income. The forward price F
0
is given by
F
0
= S
0
e
rT
,
where r is the risk-free rate, and T is the time to maturity. If K is the delivery price for a
contract that was negotiated some time ago, the value of the forward contract f today is
f = (F
0
K)e
rT
= S
0
Ke
rT
.
5.3 Suppose that you enter into a 6-month forward contract on a non-
dividend-paying stock when the stock price is $30 and the risk-free interest
rate (with continuous compounding) is 12% per annum. What is the forward
price?
The forward price is
$30e
0.120.5
= $31.86.
5.5 Explain carefully why the futures price of gold can be calculated from the
spot price and other observable variables whereas the futures price of copper
cannot.
Gold is an investment asset. Its futures price as a function of the spot price of gold S
0
, the
risk-free rate r, and time to maturity T is
F
0
= S
0
e
rT
.
If the futures price is relatively high (F
0
> S
0
e
rT
), investors will buy gold and short fu-
tures contracts. If the futures price is too low (F
0
< S
0
e
rT
), they will sell or short gold
and long futures contracts.
Copper is a consumption asset. If the futures price is too high, buying copper and shorting
futures contracts is protable. However, because investors do not in general hold the asset,
the strategy of selling copper and buying futures is not available to them. Therefore, there
is an upper bound, but not a lower bound, to the futures price.
5.6 Explain carefully the meaning of the terms convenience yield and cost of
carry. What is the relationship between futures price, spot price, convenience
yield, and cost of carry?
Ownership of the physical commodity may provide benets that are not obtained by holders
of futures contracts. These benets from owing the physical asset are referred to as the
convenience yield provided by the commodity.
The cost of carry is the interest that is paid to nance the asset plus the storage cost less
the income earned on the asset.
The relationship between the futures price (F
0
), the spot price (S
0
), the convenience yield
(y), and the cost of carry (c) is
F
0
= S
0
e
(cy)T
,
2
where T is the time to maturity of the futures contract.
5.14 The 2-month interest rates in Switzerland and the United States are,
respectively, 3% and 8% per annum with continuous compounding. The spot
price of the Swiss franc is $0.6500. The futures price for a contract deliverable
in 2 months is $0.6600. What arbitrage opportunities does this create?
The theoretical futures price for a contract deliverable in two months is
0.6500e
(0.080.03)
2
12
= $0.6554.
The actual futures price is, therefore, too high. An arbitrageur would buy Swiss francs and
short Swiss francs futures.
5.16 Suppose that F
1
and F
2
are two futures contracts on the same commod-
ity with times to maturity, t
1
and t
2
, where t
2
> t
1
. Prove that
F
2
F
1
e
r(t
2
t
1
)
,
where r is the interest rate (assumed constant) and there are no storage costs.
For the purposes of this problem, assume that a futures contract is the same
as a forward contract.
Assume that
F
2
> F
1
e
r(t
2
t
1
)
.
It is easily seen that this situation gives rise to arbitrage opportunitties. An investor can
make a riskless prot by
1. Taking a long position in a futures contract which matures at time t
1
.
2. Taking a short position in a futures contract which matures at time t
2
.
When the rst futures contract matures, the asset is purchased for F
1
using funds borrowed
at rate r. It is then held until time t
2
at which point it is exchanged for F
2
under the second
contract. The costs of the funds borrowed and accumulated interest at time t
2
is F
1
e
r(t
2
t
1
)
.
A positive prot of
F
2
F
1
e
r(t
2
t
1
)
is then realized the time t
2
. This arbitrage opportunity would not exist for a long time.
Therefore,
F
2
F
1
e
r(t
2
t
1
)
.
5.20 Show that equation (5.3) is true by considering an investment in the asset
combined with a short position in a futures contract. Assume that all income
from the asset is reinvested in the asset. Use an argument similar to that in
footnotes 2 and 4 and explain in detail what an arbitrageur would do if equation
(5.3) did not hold.
Suppose we buy N units of the asset and the income from the asset is reinvested in the
asset. The income from the asset causes the holding of the asset to grow at a continuously
compounded rate q. By time T the holding has grown to Ne
qT
units of the asset. We,
3
therefore, buy N units of the asset at time zero at a cost of S
0
per unit, and enter into a
forward contract to sell Ne
qT
units for F
0
per unit at time T. The cash ows from this
strategy are
Time 0 : NS
0
Time T : NF
0
e
qT
Because there is no uncertainty about these cash ows, the present value of the time T
inow must equal the time zero outow when we discount at the risk-free rate.
NS
0
= (NF
0
e
qT
)e
rT
,
i.e.
F
0
= S
0
e
(rq)T
,
which is exactly equation (5.3).
If F
0
> S
0
e
(rq)T
, an arbitrageur would borrow money at rate r and buy N units of the
asset. At the same time the arbitrageur would enter into a forward contract to sell Ne
qT
units of the asset at time T. As income is received, it is reinvested in the asset. At time T
the loan is repaid and the arbitrageur makes a prot of N(F
0
e
qT
S
0
e
rT
).
If F
0
< S
0
e
(rq)T
, an arbitrageur would short N units of the asset investing the proceeds
at rate r. At the same time the arbitrageur would enter into a forward contract to buy
Ne
qT
units of the asset at time T. When income is paid on the asset, the arbitrageur owes
money on the short position. The investor meets this obligation from the cash proceeds of
shorting further units. The result is that the number of units shorted grows at rate q to
Ne
qT
. The cummulative short position is closed out at time T and the arbitrageur makes
a prot of N(S
0
e
rT
F
0
e
qT
).
4