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.
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:
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
(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.
(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