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EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

EF4420 Derivative Analysis and Advanced Investment Strategies


Problem Set 3

This problem set is to be turned in by Friday, February 17th 11:00 pm. Please present your work using MS
Word or PDF and submit online on Canvas. You may use Excel for calculation but the final solution should
be presented in MS Word or PDF.

1. Forward on Zero Coupon Bond


Consider a 1-year forward contract on a zero coupon bond with 3-year maturity. The face value of the bond
is $100. The following is the current term structure of risk-free rate:
maturity (years) interest rate
1 2%
2 2.5%
3 3%
(a) If there is no arbitrage, what is the forward price?

Solution: First, the price of the 3-year zero coupon bond is 100e0.033 = $91.393. Then, the forward
price is
F0 = S0 erT = (91.393)e0.021 = $93.239.

(b) A bond investor wants to hedge and takes a short position in the forward. One year later, the term
structure of the risk free rate changes as follows:

maturity (years) interest rate


1 1.5%
2 2%
3 2.4%

What is the payoff of the short position of the forward?

Solution: Now the bond we have will expire after two years. Thus, the bond value is 100e0.022 =
$96.079. Then, the payoff for the short position in the forward is

F0 S1 = 93.239 96.079 = $2.840.

1 Instructor: Yongjin Kim


EF4420 Derivative Analysis and Advanced Investment Strategies - Semester B 2016/2017

2. Arbitrage Using a Forward on Dividend-Paying Stock


Consider a stock that will pay $2-dividend in year 1 and $3-dividend in year 3. The current stock price is
$70. The risk-free rate is 3% for all maturities.

(a) Consider a 2-year forward on the stock. In order for an arbitrage not to exist, what should be the
forward price?

Solution: First, the ex-dividend price of the stock is (note that year-3 dividend will be paid after the
forward maturity)
70 2e0.031 = $68.059.

Then, the forward price is


(68.059)e0.032 = $72.268.

(b) Suppose that the forward price is $67. Is there an arbitrage? If so, show the arbitrage strategy.

Solution: As 67 < 72.268, an arbitrage exists. We can consider the following strategy:

Action Cash flow in year 0 Cash flow in year 1 Cash flow in year 2
long forward 0 (ST 67)
sell stock 70 -2 -ST
0.03
buy 1-year bond -2e 2
0.03
buy 2-year bond -(70 2e ) (70 2e0.03 )e0.032
net 0 0 (70 2e0.03 )e0.032 67
| {z }
=5.268

2 Instructor: Yongjin Kim