Prof.

Roberto Steri Derivatives I - Problem Set 2 Spring 2019

Problem Set 2
Suggested Deadline: 25/03/2019

Forward and Futures Prices

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

1. A hedge fund manager is analyzing the following two assets: a non-dividend paying stock in
the IT sector listed at S0 = 95$, and a zero-coupon bond with a maturity of one year with
price B0 = 98$ and face value 100$. The following futures contracts are traded:
Underlying Futures Price Maturity
Stock 95:5$ 6 months
Bond 98:0$ 6 months

The six-month LIBOR rate is r = 0:5%.

a) Show that there are arbitrage opportunities in the market. Propose a trading strategy
that the fund’s manager could use to take advantage of arbitrage opportunities.
b) If the fund’s manager decides not to operate in the bond market and has a borrowing
constraint such that he cannot borrow more than 9; 500; 000$, what is the maximum
arbitrage pro…t the fund can make in the stock market using the strategy at point a)?
Suppose the hedge fund is a marginal trader and extant prices do not signi…cantly move
because of its trading activity.
c) The fund’s manager is o¤ered a long position in a forward structured product with
6-month maturity for an immediate cash payment of $. The payout of the product
after three months is the di¤erence between the current stock and bond prices, and at
maturity is the sum of the stock and bond prices. If both the stock and the bond are
now (t = 0) traded at their no-arbitrage prices, what is the no-arbitrage price of the
structured product? Assume the interest rate will be approximately constant in the next
six months, and that forward and futures prices are equivalent.

Solution
S B
a) The no-arbitrage futures prices F0;N A and F0;N A for the contracts on the stock and bond
respectively are:
S rT
F0;N A = S0 e = 95 e0:005 0:5 = 95:238$
B rT
F0;N A = B0 e = 98 e0:005 0:5 = 98:245$
Since the stock futures price is above the no-arbitrage price, and the bond futures price is
below the no-arbitrage price, there are arbitrage opportunities in the market. The follow-
ing strategy allows to gain sure pro…ts and take advantage of the arbitrage opportunity
in the stock market

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

and the following allows to take advantage of the arbitrage opportunity in the bond
market

where ST and BT are the stock and bond prices at maturity.

b) The maximum amount the manager can borrow to implement the strategy above in the
stock market is 9; 500; 000$, that corresponds to a purchase of 100,000 shares. The pro…t
per share is:
F0S S0 er T = 95:5 95:238 = 0:262$
The total pro…t is therefore

100000 0:262 = 26; 200$

c) Consider the following strategy

where P0 is the no arbitrage price of the structured product, and S3 and B3 are the stock
and bond prices in three months respectively. By no arbitrage, P0 must be set such that
the terminal cash ‡ow is also zero, that is

P0 = 2 S0 = 95 2 = 190$

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

2. WireFire is a …rm based in California that operates in the IT sector. WireFire’s stocks will
pay a dividend of 0:1$ three months from now. Then, the dividend policy of the company
is such that dividends will grow inde…nitely at the rate of 0:5% per quarter. WireFire is
currently traded at 20$ per share. The following data for the riskfree yield curve are given:
Rate Maturity
0:25% 3 months
0:30% 6 months
0:45% 9 months
0:75% 12 months

a) What is the no-arbitrage price of a forward contract on WireFire’s stock with one-year
maturity? Dividends in one year from now are paid just before the contract expires.
b) ConnectPeople is another …rm in the IT sector, whose shares are traded at 15$. Con-
nectPeople pays quarterly dividends and the …rm has a di¤erent policy from WireFire,
namely keeping a constant dividend yield of 1% per year. An investment fund that trades
in IT stocks is asking a bank for a 1-year long forward contract on a portfolio of 4; 000
shares of WireFire and 6; 000 shares of ConnectPeople. The bank quotes a contract price
of 1650, where the contract size is 10; 000 shares and the price is quoted in cents per
share. Is there an arbitrage opportunity that the fund can exploit?
c) Another investment fund has just entered a short position of 100; 000 shares of WireFire
in its portfolio at the current market price. The fund has an investment horizon of
one year, but after ascertaining new information about WireFire’s reorganization the
manager is worried about the possibility of a good performance of the stock. The fund’s
manager is now unsure about the share price but, unlike other market participants, he
is convinced that WireFire will unexpectedly stop paying dividends before next year
due to current liquidity shortfalls. The fund is negotiating a long position in a forward
contract on WireFire with a bank, which does not share the manager’s concerns. The
fund’s manager always re-invests dividend payments and proceeds from short sales at
the riskfree rate with continuous compounding.
– Which trading strategy may the manager use to hedge price risk and gain if dividend
payments are reduced?
– Assume the manager’s forecast is right, and WireFire will stop paying dividends in
four months from now. What is the performance of your strategy if WireFire’s price
decreases by 1:5%? What is the performance of your strategy if WireFire’s price
increases by 1:5% instead?
– What is the pro…t of the strategy if dividends do not change instead?

Solution

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

a) The present value P V (D) of WireFire’s dividends up to maturity is

P V (D) = 0:1 e 0:0025 0:25 + 0:1 (1:005) e 0:0030 0:50 +

0:1 (1:005)2 e 0:0045 0:75: + 0:1 (1:005)3 e 0:0075 1:0 = 0:4017$

The forward price F0 is therefore

F0 = [S0 P V (D)] er T =
= (20 0:4017) e0:0075 1 = 19:746$

b) The current value of the portfolio S0P is

S0P = 4000 20 + 6000 15 = 170; 000$

The present value of the dividend income from the 4000 shares of WireFire is P V P (D) =
4000 0:4017 = 1606:8 $. The dividend yield from the 6000 shares of connect people with
0:6 15
respect to the portfolio’s value is dP = 0:6 15+0:4 20
0:01 = 0:5294% per year. The
P
no-arbitrage price F0 of the forward contract on the portfolio is:
dP ) T
F0P = S0P P V P (D) e(r =
= (170000 1606:8) e(0:0075 0:005294) 1
= 168; 765$

The price the bank quoted for 1 contract (10,000 shares) is

1650 $
10000 shares = 165; 000$
100 share
There is therefore an arbitrage opportunity the fund could exploit by taking a long
position in the contract and selling short 4; 000 shares of WireFire and 6; 000 shares of
ConnectPeople:
A long position in a contract of size of 100; 000 shares allows to hedge price risk and to
lock the purchase price at the forward price F0 .
Because the bank (as well as the other market participants) do not expect WireFire to
change their dividend policy, the no-arbitrage price is F0 = 19:746$, as in point a).
If WireFire’s price decreases by 1:5% to 19:7$; and fund’s manager forecast is correct
and WireFire only pays the …rst dividend three months from now, the proceeds without
entering the contract are
0 short sale dividends
1
z }| {share repurchases
z }| { z }| {
100000 @20 e0:0075 1:0 19:746 F V (D)A =

100000 20 e0:0075 1:0 19:746 0:10069 = 30; 387$

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

where the future value of dividends per share (reinvested at the riskfree rate) is now
0:0025 0:25
F V (D) = 0:1 e e0:0075 1:0 = 0:10069$

Notice that since the bank does not expect a change in WireFire’s dividend policy, the
contract price does not re‡ect it. As standard, if the borrowed stock pays a dividend,
the short seller is responsible for paying the dividend to the person or …rm making the
loan. If WireFire’s price increases by 1:5% to 20:3$, the performance is the same since
the price is locked to the forward price.
If dividends stay the same, that is F V (D) = 0:4017 e0:0075 1:0 = 0:40472 $, the perfor-
mance of the strategy is:
0 short sale dividends
1
z }| {share
z
repurchases
}| { z }| {
100000 @20 e0:0075 1:0 19:746 F V (D)A =

100000 20 e0:0075 1:0 19:746 0:40472 = 15:61$

c) A long position in a contract of size of 100; 000 shares allows to hedge price risk and to
lock the purchase price at the forward price F0 .
Because the bank (as well as the other market participants) do not expect WireFire to
change their dividend policy, the no-arbitrage price is F0 = 19:746$, as in point a).
If WireFire’s price decreases by 1:5% to 19:7$; and fund’s manager forecast is correct
and WireFire only pays the …rst dividend three months from now, the proceeds without
entering the contract are
0 short sale dividends
1
z }| {share repurchases
z }| { z }| {
100000 @20 e0:0075 1:0 19:746 F V (D)A =

100000 20 e0:0075 1:0 19:746 0:10069 = 30; 387$

where the future value of dividends per share (reinvested at the riskfree rate) is now
0:0025 0:25
F V (D) = 0:1 e e0:0075 1:0 = 0:10069$

Notice that since the bank does not expect a change in WireFire’s dividend policy, the
contract price does not re‡ect it. As standard, if the borrowed stock pays a dividend,
the short seller is responsible for paying the dividend to the person or …rm making the
loan. If WireFire’s price increases by 1:5% to 20:3$, the performance is the same since
the price is locked to the forward price.

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

If dividends stay the same, that is F V (D) = 0:4017 e0:0075 1:0 = 0:40472 $, the perfor-
mance of the strategy is:
0 short sale dividends
1
z }| {share
z
repurchases
}| { z }| {
100000 @20 e0:0075 1:0 19:746 F V (D)A =

100000 20 e0:0075 1:0 19:746 0:40472 = 15:61$

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

3. Consider the following table reporting spot and three-months-from-today (i.e. six-months-
from-three-months-ago) futures prices for crude oil at two di¤erent points is time:

3 Months Ago Today

Spot 95:000$ 97:000$
Futures 95:667$ 97:316$

The following data on the yield curve today and three months ago are given:

3 Months Ago Today

Rate Maturity Rate Maturity
0:20% 3 months 0:30% 3 months
0:40% 6 months 0:50% 6 months

Suppose crude oil has a storage costs equal to s = 2% and a convenience yield of y = 1% of
the spot price.

a) What is the delivery price of a futures contract issued today with three-month maturity?
And of a contract issued three months ago with six-month maturity?
b) What is the current value of a three-month long futures contract issued today? What is
the current value of a three-month short futures contract issued three-months ago?
c) Consider another three-month long forward contract issued today and that has the short
forward contract issued three months ago as the underlying. A bank o¤ers you the new
customized contract for free, that is with no payments at any point in time. Is there an
arbitrage opportunity? If this is the case, propose a trading strategy to take advantage
of it. In developing your strategy, recall you can neither buy/sell the contract issued
three-months ago directly nor short the contract the bank is proposing you.
d) Would your answer change if the bank would be o¤ering a three-month short forward
contract issued today and that has the short forward contract issued three months ago
as the underlying with a futures price of 1$? (i.e. you pay 1$ to sell)

Solution

a) At the time of entering the contract the delivery price is equal to the forward price.
Therefore, the …rst contract is a commitment to buy/sell three months from now at
97:316$, and the second contract is a commitment to buy/sell three months from now at
95:667$.

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

b) The current value of a three-month long forward contract issued today is zero. The
current value of a three-month short forward contract issued three-months ago is
3 months r3today (T t)
ftoday = (K3 months Ftoday ) e

where K0 = 95:667$ is the delivery price on the contract issued three months ago,
Ftoday = 97:316$ is the current three-month forward price, r3today = 0:3% is the three-
month interest rate today, and T t = 0:25 years is the time to maturity. This yields:
3 months
ftoday = (95:667 97:316) e( 0:003) (0:25)
= 1:6478$

c) The no-arbitrage future price FF of the futures-on-futures is

today
3 months
FF = ftoday er3 (T t)
= 1:6478 e(0:003) 0:25 = 1:649$

that is you should receive about 1:65$ at maturity if you enter the contract. The bank
is o¤ering the contract at a price which is too high, namely 0$.
Consider the following trading strategy, which does neither short the futures on futures
nor sells the contract initiated three months ago:

– where K3 is the delivery price for the contract issued today and ST is the underlying
price at maturity.
The strategy requires zero initial outlay, and delivers a sure pro…t equal to

K0 K3 FF

Since the bank o¤ers FF = 0, the pro…t is 95:667 97:316 = 1:649$; a loss. Because to
take advantage of an overpriced contract it is necessary to sell it, and since the bank will
probably not o¤er the same value of FF for the short forward contract, the short-sale
constraint prevents you to exploit deviations from the no-arbitrage price.
d) Consider the following strategy:

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

The strategy requires zero initial outlay, and delivers a sure pro…t equal to

K3 K0 + FF

Since the bank o¤ers FF = 1$, the pro…t is 97:316 95:667 1 = 0: 649$; a sure gain.

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

4. The S&P 500 index is currently quoted at 1950 index points. An index futures on the S&P 500
with three-month maturity is quoted at 1941.7 index points. The S&P 500 is a value-weighted
index. The three-month LIBOR rate is 0.3%.

a) What is the three-month dividend yield implied by the futures prices?

b) The stock price of Bank of America, a constituent of the S&P 500 index, suddenly goes up
by 5%, while all the prices of the other constituents remain roughly unchanged. There
are no news that suggest that the dividend policy of the …rms in the S&P 500. may
change The current market capitalization of Bank of America is 200 billion $, and the
current market capitalization of the S&P 500 index is 10,000 billion $. The index value
increases to 1952, and the index futures value decreases to 1935. Are there arbitrage
opportunities in the market? If this is the case, how could a hedge fund exploit them?
Assume there is an ETF the market which tracks the S&P 500 index.
c) Suppose now that after the price increase of Bank of America, the index value increases
to 1960 and the index futures value to 1951.7. Are there arbitrage opportunities in the
market? If this is the case, how could a hedge fund exploit them? Assume there is an
ETF the market which tracks the S&P 500 index.

In computing numerical approximations, round all index values, prices, and percentages to
the …rst decimal digit.
Solution

a) Denote as: F0 the futures price in index points, S0 the index value in index points, as r
the interest rate, as d the dividend yield, and as T the maturity in years. Then:

F0 = S0 e(r d) T

from which
1 S0 1 1950
d=r+ ln = 0:003 + ln = 2%
T F0 0:25 1941:7
b) After the price increase, the market price of Bank of America becomes 200 (1:05) =
210:0 billion $. The market cap of the index becomes 10000+ 0:05 200 = 10010 billion
$. The index value S0 therefore goes up to
10010
S00 = 1950 = 1952
10000
By no arbitrage, the forward price should go up to

F0N A = S00 e(r d) T

= 1952 e(0:003 0:02) 0:25
= 1943:7

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

Since F00 = 1935 < S00 e(r d) T = 1943:7, a hedge fund could then take a long position
in the future (buy cheap) and short the ETF on the index. Notice that in reality you
cannot short neither indexes directly, nor index funds - but only ETFs (another way to
gain from price decreases is to buy an inverse ETF).
c) In this case, given the new value of the index (S00 = 1960), there are no arbitrage
opportunities between spot and future prices, since

F00 = 1951:7 = F0N A = 1960 e(0:003 0:02) 0:25

= 1951:7

However, the index value increases too much with respect to the value of its constituents,
since S00 = 1960 > 1952, where 1952 is the change in index points that re‡ects the change
in the market value of the index. An possible arbitrage strategy is therefore to short the
ETF (sell expensive) and to buy all constituents in appropriate proportions, including
Bank of America’s shares (buy cheap). In fact:
PN PN 1
pi Qi
n=1 n=1pi Qi pIBOA QBOA
S0 = = +
Divisor Divisor Divisor
where S0 is the index value, N is the number of constituents, pi is the i-th constituent
price, Qi is the i-th constituent number of shares, QBOA is Bank of America’s number of
shares, pIBOA is Bank of America’s share price implied by the index value , and Divisor is
the index divisor, that is a scaling variables to convert market capitalizations into index
points (see, for example, S&P Dow Jones Indices: Index Methodology, March 2014). The
Qi
proportions of the constituents to buy are given by Divisor , such that each dollar invested
in the strategy yields:
proceeds from short sales
z P }| {
N 1 I
pi Qi pBOA QBOA
+ n=1 +
Divisor Divisor
investment expenses
z P }| {
N 1
n=1pi Qi pBOA QBOA
Divisor Divisor
(pIBOA pBOA ) QBOA
= Divisor
>0
where pBOA is Bank of America’s share price in the market.

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

5. Five years from your graduation you are running a trading desk at a Swiss bank. The spot
exchange rate is 0:805 USD/CHF, the 6-month forward CHF/USD exchange rate is 1:25 CHF
USD
,
and the 6-month CHF risk-free rate 2.50%. All rates are annualized and continuously com-
pounded.

a) What must the 6-month USD risk-free interest rate be (annualized, continuously com-
pounded) if there is no arbitrage?
b) Suppose that the 6-month USD risk-free interest rate is 2% (annualized, continuously
compounded). Describe exactly what transactions you, as a Swiss trader, would under-
take to generate an arbitrage pro…t using the contract described above. How much would
be the arbitrage pro…t in your domestic currency in six months if you can borrow at most
1,000 CHF today?
c) One of the bank’s corporate customers is a US …rm operating it the IT sector. The
US …rm sells computers to a large Swiss customer for a value on 1,000,000 CHF. The
payment of the computers is due in 90 days (use 360 days per year). The 3-month
forward USD/CHF exchange rate is 0:806. What is the minimum USD amount you
would charge your customer for a forward agreement that allows it to lock the value of
its account receivables to 0:815 USD/CHF?
d) The interest rate in Swizerland increases to 3% and your customer asks for a 10% discount
on the fee at point c) before going to your competitor. Are you willing to accommodate
its request? In the case your answer is positive, what is the minimum fee you would
charge?

Solution

a) Consider the position of a US investor who is investing in Switzerland at the riskfree rate
rCH = 0:025. The CHF/USD forward price F0 is such that
CH rU S ) T
F0 = S0 e(r

1 CHF
where S0 = 0:805 U SD
, T = 0:5. Hence:

1 F0 1 1:25
rU S = rCH ln = 0:025 ln 1 = 1:254%
T S0 0:5 0:805

b) With rU S = 2% the forward no-arbitrage exchange FN A rate should be

CH rU S ) T 1 CHF
FN A = S0 e(r = e(0:025 0:02) 0:5
= 1:2453
0:805 USD

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

CH US
Since F0 > FN A = S0 e(r r )T
, it means that F0 erU S T > S0 erCH T . Hence,
investing at the 2% rate in USD and selling USD for CHF at maturity using the extant
futures contract is relatively more convenient than changing USD in CHF on the spot
and investing in Switzerland at a rate or 2:5%. Thus, a short position in the futures
contracts today allows to sell USD and buy CHF for a relatively high price (F0 ) in six
months.
Thus, the following trading strategy allows to take advantage of the arbitrage opportu-
nity, with a "free lunch" of 3.80 CHF in six months.

c) The described forward contract is similar in structure to a forward rate agreement (FRA).
However, the underlying is not an interest rate, but an exchange rate, so there are no
compounding specs to specify as in FRAs. First, notice that the US customer needs
to pay a fee to the bank because she is willing to buy dollars in three months at a
USD/CHF exchange rate (0:815) above the current forward rate for the same period
(0:806) - otherwise there would be no extra fee and the FOREX receivables could be
simply hedged using the available forward rate. Denote as R = 1 mln CHF the amount
of FOREX receivables to hedge, as x = 0:806 the current forward exchange rate, as
90
xF = 0:815 the ad-hoc contract exchange rate, as T = 360 = 0:25 years the time when
US
receivables will be paid, and r = 0:02 the US interest rate. The minimum fee the Swiss
bank is willing to accept is:
rU S T
f ee = R (xF x) e =
0:02 0:25
= 1000000 (0:815 0:806) e = 8955:1 USD

d) Although in the formula for the fee the Swiss interest rate rCH does not appear explicitly,
the no arbitrage forward rate x depends on rCH because
US r CH ) T
x = x(rCH ) = S0 e(r

If rCH increases, the cost of carring CHF instead of USD would decrease, and the current
forward rate x would increase. The fee would therefore increase. In particular, with

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

rCH = 0:03
US r CH ) T
x(rCH ) = S0 e(r = 0:805 e(0:02 0:03) 0:25
= 0:803

and the fee becomes

0:02 0:25
1000000 (0:815 0:803) e = 11940 USD

A 10% discount would correspond to a new fee of 8955:1 (0:9) = 8059: 6 USD. Therefore,
you should not give your client a discount.

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Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

6. GreenGas is a company based in Pekin, Illinois, that employs ethanol in its production process,
and needs to purchase 290,000 gallons of it in three months. The three-month futures price
of ethanol contracts traded on CBOT is 1.55 $/gallon, and the spot price of ethanol is 1.5
$/gallon. The contract size is 290,000 gallons. The three-month interest rate is 0.25%. Ethanol
is stored in steel fuel tanks, and the convenience yield of holding ethanol in the next three
months is negligible.

a) CoolTanks is a company that rents storage services for business clients operating in
Illinois. CoolTanks uses proprietary and patented technologically advanced probes and
pumps that guarantee a higher storage e¢ ciency than traditional technologies. Currently,
CoolTanks can store each gallon of ethanol at a annualized and continuously compounded
cost s = 5% of the current spot price. How much could CoolTanks charge GreenGas at
most for storing 290,000 gallons of Ethanol for three months?
b) Suppose CoolTanks has a 2.9 mln gallons idle capacity for the next three months. Can
CoolTanks make arbitrage pro…ts in the market? If this is the case, what is the sequence
of transactions that CoolTanks can implement to do so? How much could CoolTanks
potentially gain three months from now?

Solution

a) The present value S of storage costs for each gallon on ethanol implied by no-arbitrage
futures prices is such that
F0 = (S0 + S) er T

where S0 = 1:5 is the spot price of ethanol, F0 = 1:55 is the forward price of ethanol,
r = 0:0025 is the interest rate, and T = 0:25 is the contract maturity. Solving for
yields
S = F0 e r T S0 = 1:55 e 0:0025 0:25 1:5 = 0:049$

Since GreenGas would need to store 290,000 gallons the present value of the costs is
0:049 290000 = 14210$.
With continuous compounding, CoolTanks’cost C of storing ethanol is
quantity
z }| {
290000 1:5 (e0:05 0:25 1) = 5471:6$
| {z }
3-month unit
storage cost

Thus CoolTanks could charge GreenGas up to 14210$, with a pro…t of 14210 5471:6 =
8738:4$

16
Prof. Roberto Steri Derivatives I - Problem Set 2 Spring 2019

b) The fair price F CT of futures contracts from CoolTanks perspective would be:

F CT = S0 e(r+s) T

where s = 0:05. This yields:

F CT = 1:5 e(0:0025+0:05) 0:25 = 1:5198$

Since F CT < F0 , the CoolTanks can make arbitrage pro…ts by purchasing and stor-
ing ethanol up to capacity and entering short futures positions. The following trading
strategy

guarantees an arbitrage pro…t of F0 S0 e(r+s) T = F0 F CT per gallon. CoolTanks

can use its capacity (2.9 mln gallons) to store up to a quantity to trade in 2900000
290000
= 10
contracts. Hence, the total arbitrage pro…t is:

10 290000 (1:55 1:5198) = 87; 580$

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