Recitation 1

Problem 1
Southern California Edison (SCE) will need to buy 200,000 barrels of oil in 10 days, and it is worried
about fuel costs rising. Suppose SCE goes long 200 oil forward contracts of the April contract (it
is March), each for 1,000 barrels of oil, at the current forward price of $50 per barrel. Suppose
forward prices change each day as follows:
Day 1 $49.75
Day 2 $47.25
Day 3 $48.50
Day 4 $49.25
Day 5 $49.50
Day 6 $50.75
Day 7 $51.25
Day 8 $50.50
Day 9 $51.75
Day 10 $52.50

(a) What is the mark-to-market profit or loss (in dollars) that SCE will have on each date?

Solution: Define FT to be the forward price for Day T and N to be the number of barrels of
oil in each forward contract. The mark-to-market profit/loss (P/L) on each forward contract on
Day T is equal to N × (FT − FT −1 ) for a long position and N × (FT −1 − FT ) for a short position.

Let F0 be the current forward price of $50. Since SCE has a long position in 200 forward contracts
with a size of N = 1, 000 barrels for each contract, SCE’s P/L on Day 1 is:

200 × [N × (F1 − F0 )] = 200 × [1, 000 × (49.75 − 50)] = −$50, 000.

In other words, SCE makes a mark-to-market loss of $50,000 on Day 1.

Similarly, on Day 2, SCE’s P/L is:

200 × [N × (F2 − F1 )] = 200 × [1, 000 × (47.25 − 49.75)] = −$500, 000.

Iterating the calculation above for Days 3-10, SCE’s daily P/L is displayed in the table below:

1
 Day 1 -$50,000
Day 2 -$500,000
Day 3 $250,000
Day 4 $150,000
Day 5 $50,000
Day 6 $250,000
Day 7 $100,000
Day 8 -$150,000
Day 9 $250,000
Day 10 $150,000

(b) What is SCE’s total profit or loss after 10 days?

Solution: Recall that SCE’s P/L on its long position in each forward contract on Day 1 is
N × (F1 − F0 ) and on Day 2 is N × (F2 − F1 ). Summing these two quantities, we see that
SCE’s P/L after 2 days is:

[N × (F1 − F0 )] + [N × (F2 − F1 )] = N × (F2 − F0 ).

Iterating this logic forward to Day 10, we see that SCE’s P/L on each forward contract after 10
days is given by N ×(F10 −F0 ). Thus, SCE’s total P/L on its long position in 200 forward contracts
after 10 days is:

200 × [N × (F10 − F0 )] = 200 × [1, 000 × (52.50 − 50)] = $500, 000.

(c) Explain why this may not be a perfect hedge for SCE.

Solution: A couple reasons why this strategy may not be a perfect hedge for SCE include:

1. The interest earned on the margin account was not included in the calculations and will affect
SCE’s payoff.

2. Not all oil is the same! Oil prices differ based on quality and location, so the reference price
in the forward contract may not be perfectly correlated with the cash purchase price that SCE
faces.

Problem 2
A stock is expected to pay a dividend of $1 per share in two months and in five months. The stock
price is $50, and the risk-free rate of interest is 8% per annum with continuous compounding for all
maturities. An investor has just taken a short position in a six-month forward contract on the stock.

(a) What are the forward price and the initial value of the forward contract?

Solution: We’ll solve this problem in three steps.

1. Using the given risk-free rate, find the present value of the stock’s expected dividends.

Let t denote the time in years and r be the continuously-compounded, constant risk-free rate ex-
pressed in decimal form. As we saw in lecture, we can discount any cash flow arriving at time t

2
back to the present using the expression P V = D × e−r×t on a continuous basis, where D is the
cash flow (in dollars) and P is its present value.

Thus, the present value of the $1 dividends we expect to receive in two and five months is:
I = 1 × e−0.08×2/12 + 1 × e−0.08×5/12 = $1.954.
2. Find the forward price of the stock using the equation we learned in lecture.
Recall from lecture that we can calculate the forward price of a stock as:
F0 = (Ps,0 − I)er×T ,
where F0 is the initial forward price, Ps,0 is the current price of the stock, and T is the time to
maturity of the forward contract in years.

Plugging in Ps,0 = $50, I = $1.954, and T = 0.5, we get that the forward price is:
F0 = (50 − 1.954)e0.08×0.5 = $50.01.
3. Find the initial value of the short position in the forward contract.
This not so hard, really! As discussed in lecture, in the absence of arbitrage, all forward con-
tracts must have a net present value of 0 at inception. Why?

Let Ps,0 be the current price of the stock underlying the forward contract. The cash flows from
a forward short position are equivalent to those obtained by simultaneously lending −Ps,0 dollars
today and shorting the stock at Ps,0 .

Clearly, the net cash flow today from this “reverse cash-and-carry” strategy is 0, so by the Law of
One Price, the net present value of the short position in the forward contract is also 0.

(b) Three months later, the price of the stock is $48 and the risk-free rate is still 8% per an-
num. What are the forward price and the value of the short position in the forward contract?

Solution: Let’s go through our three steps again.

1. Using the given risk-free rate, find the present value of the stock’s expected dividends.
Since we originally expected to receive $1 dividends in two and five months, three months later we
now expect to receive a single dividend in two months. The risk-free rate is still 8%, so the present
value of this dividend is:
I = 1 × e−0.08×2/12 = $0.9868.
2. Find the forward price of the stock using the equation we learned in lecture.
Suppose Ft is the forward price for a contract negotiated at time t (in years), Ps,t is the stock price
at time t, and T is the time to maturity of the contract (also in years). In this general form, our
equation for the forward price of a stock is now:
Ft = (Ps,t − I)er×T .
Plugging in Ps,t = $48, I = $0.9868, and T = 0.25, we can find the forward price of the stock three
months later (i.e., at t = 0.25):
F0.25 = (48 − 0.9868)e0.08×3/12 = $47.96.

3
3. Find the value of the short position in the forward contract.

In lecture, we saw that the value of a short position in a forward contract at time t is given by:

ft = (F0 − Ft )e−r×(T −t) .

Thus, we can find the value of a short position in the forward contract three months later by
plugging in F0 = $50.01, F0.25 = $47.96, T = 0.5, and t = 0.25, into the equation above:

f0.25 = (50.01 − 47.96)e−0.08×(0.5−0.25) = $2.01.

Problem 3
A company enters into a forward contract with a bank to sell a foreign currency for K1 at time
T1 . The exchange rate at time T1 proves to be S1 > K1 . The company asks the bank if it can roll
the contract forward until time T2 > T1 rather than settle at time T1 . The bank agrees to a new
delivery price, K2 . Explain how K2 should be calculated.

Solution: As a convention, assume that the exchange rate is quoted as the number of units
of domestic currency per unit of foreign currency. So, if the exchange rate goes up, then the foreign
currency has appreciated —i.e., its price in terms of the domestic currency has increased. Also, note
that the bank has a long position in the forward contract, and hence has agreed to buy the foreign
currency in the future.

First, let’s find the value of the forward contract to the bank at T1 . Since the spot exchange
rate S1 at T1 is greater than the forward exchange rate K1 , the bank can purchase the foreign
currency at a lower price using the forward contract than on the spot market. Thus, the value of
the forward contract to the bank is equal to the cost savings from purchasing the foreign currency
with the forward contract, which is S1 − K1 .

Now, how will the bank optimally choose the new delivery price K2 at T2 ? To be as well off
as before, the bank requires the value of the new, rolled-forward contract at T1 to be equal to
S1 − K1 . This implies that

S1 × e−rf (T2 −T1 ) − K2 × e−r(T2 −T1 ) = S1 − K1 ,

where r and rf are the domestic and foreign risk-free rates, respectively, observed at T1 and appli-
cable to the period between T1 and T2 . The first term on the LHS, S1 × e−rf (T2 −T1 ) , is the present
value of investing S1 units of the foreign currency at the foreign risk-free rate of rf from T1 to T2 .
The second term on the LHS, K2 × e−r(T2 −T1 ) , is the present value of investing K2 units of the
foreign currency at the foreign risk-free rate of rf from T1 to T2 .

Solving for K2 , we see that:

K2 = S1 × e(r−rf )(T2 −T1 ) − (S1 − K1 ) × er(T2 −T1 ) .

So, there are two components to K2 : (i) the forward price at time T1 and (ii) an adjustment to the
forward price equal to the bank’s gain on the first part of the contract compounded forward at the
domestic risk-free rate.