Homework Practice Problems with Solutions and Assignment Questions

Please go through all the practice problems before attempting

the HW assignments. The more problems you do before
attempting the Homework problems the better!
Good Luck
 Practice Problems with Solutions

Problem 1

In January, firm ABC enters into a long position in a forward contract with firm DEF as a
counterparty. The contract requires delivery in nine months time. The forward price is
set at $100 per unit and 1000 units are involved in the transaction. Three months
later DEF is offering 6 month contracts at a forward price of $80.At this time ABC
realizes that it does not need the underlying commodity in the future and is keen to
negotiate a price with DEF to terminate the contract. If interest rates at 10% per year,
continuously compounded, what is the fair compensation ABC should pay DEF?

Solution

The initial 9 month forward contract has a forward price of 100. Three months later, with
6 months to go to delivery the forward price for the same delivery date is 80.
The change in the forward price is -20. However, the value of the forward contract is not
-20. To compute the value we need to know the discount factor for 6 months which is
e-0.10(0.5)= 0.9512
So the value is -20(0.9512)=-19.024548.

Since each contract involves 1000 units, ABC should pay $19,024.58.

Problem 2

Solution

S(0) = 2.18
F = 2.24
T = 3 months
Storage cost at date 0 = 3c
r = 0.10

The farmer has two choices:

Sell now at 2.18
Sell forward at 2.24. If you do this you incur a cost of 3 cents for storage.
The present value of this strategy is
PV=2.24*e-0.10(0.25) - 0.03= 2.155

Clearly it is better for the farmer to sell now!

( You could find the farmer’s breakeven point. Only if the futures price was above 2.2659
would the holding of inventory and selling futures make sense. ( solve Fexp(-0.10(0.25))
-0.03=2.18)

Problem 3

Solution

Let FT (0) and FS (0) be the two futures prices with delivery dates S and T, with S>T. A
trader can buy the T-contract and sell the S-contract. This means the trader is committed
to buying the commodity at date T for FT (0) and then selling the same commodity (S -
T) years later. Assume the interest rate, r, remains constant. Assume further that storage
costs over the period (T,S) can be represented in date S dollars by  (T,S), and accrued
benefits over (T,S) are captured by G(T,S). Then using the cost-of-carry model, the total
cost of buying and carrying the commodity over (T,S) is

Amount borrowed at date T to pay for the underlying = FT(0)

Amount owed at date S = FT(0)er(T-S)
All storage expenses from date T to date S are borrowed. The amount you owe at date S
is π(T,S) say. Perhaps there are some benefits to having inventory over the period T to S.
let G(T,S) be the date S accrued value of the benefits. Then, the net amount owed at date
S is

FT (0)e r(S-T)   (T, S)  G(T, S)

For gold the relationship between FT (0) and FS (0) will be approximately,

FS (0)  FT (0)e r(S T) .

Here we have assumed there are no storage costs and no convenience yields on gold..

For wheat, the convenience yield enters into the analysis and
 FS (0)  FT (0)e r(S-T)   (T , S )  G(T, S)
 FT (0)e (r -u  k)(S-T)

where G(T,S) is the convenience yield over (T,S). The second line follows if the storage
and convenience yields are proportional to the value.

The convenience yield may change over time. Hence, the relationship between adjacent
futures contracts could be less stable.

Problem 4

Solution

a) S(0) = $100, T = 1 year, r = 10%.

FO T (0)  100e 0.10  $110.517

b) At t = 7 months, S(t) = $60,

FO T (t)  60e 0.10(5/12)  $62.553
  
Vt FO T (0)  FO T (t)  FO T (0) B(t,T) 
   47.964e  0.10(5/12)

 $46.00.

Problem 5
Solution

5. a) S(0) = $400, r = 10%, T = 1 year.

FT (0)  400e 0.10  $442.068 per ounce

b) Buy 1 ounce at $400  Total cost = $401.

Buy 100 ounces at $400  Total cost = $40,100.
Sell futures contract  Total cost = $25.

 Total amount borrowed = $40,125.

 Amount owed at date T = 1 year is:

40,125 e 0.10 = $44,344.98

If you assumed that the gold can be delivered against the futures contract at zero
cost, then the futures price is bounded above by $443.45.

If you assumed the gold was sold and the futures position offset, then another $1
transaction cost has to be incurred, increasing the total carry (and liquidate) value
of $44,444.98. This gives a bound of $444.45.

For the reverse cash-and-carry, we buy the futures contract at a cost of $25. We
also sell short gold. This means we borrow gold, and then sell it. We receive
$400 for the gold, we pay $1 commission, and we invest $399 in the bank, less
the $25/100 =$0.25 per ounce transaction fee for our futures. The $398.75 grows
to $440.68. At the delivery date, we take delivery of the gold, and return it. If
you assumed there was no charge here, this implies the futures price should
exceed $440.68. If you assumed you paid $1 for buying (and returning) the gold
and offset the futures contract, then the price is $439.68.

c) I will assume the futures contracts are offset. Assume the borrowing rate is 10%.
Then the cost-of-carry model is unchanged and the upper bound remains
unchanged. The lower bound, however, will change. In particular the $398.75
grows to $431.96. Then a $1 charge is incurred for the transaction in the spot.
Hence, the lower bound will now be $430.96.
Problem 6

Assume gold trades at $400. A 1 year futures contract has a price

of $420. What is the implied cost of carry rate?

Solution

T = 1 and hence
FT (0) 420
  er
S(0) 400
 420 
r = + ln   = 0.0487
 400 
 4.87%

Problem 7

A stock pays a $1 dividend in 3 months time, and a second $1 in 6

months. The stock price is $40. The riskfree rate is 10%.
(a) Compute the fair forward price of a contract that requires delivery
in 7 months time.
(b) Four months later, the stock price is $30. What is the new forward
price and what is the value of the original forward contract.

Solution

7. a) FOT(0) = 40e0.1(7/12) - 1e0.1(4/12) - 1e0.1(1/12)

= 42.4027 - 1.0338 - 1.000
= $40.3689

b) At t = 4 months, S(t) = $30.

FO T (t) = 30e 0.10(3/12)  1e 0.1(1/12)

= 30.759 - 100 .
= $29.759.

 
Vt FO T (0)   40.3689  29.759e 0.10(3/12)  $10.35

Problem 8

The current price of silver is $8 per ounce. Storage costs are

$0.10 per ounce per year. Payments are expected in two
installments, half the total cost now, with the remaining balance
due in 6 months. Interest rates are constant at 8%. Compute the
fair futures price.

Solution

S(0) = 8, r = 8%, T = 1 year.

0.10 0.08
FT (0)  S(0)e 0.08 
2
 e  e 0.08/2 
 8.66  0.05  2.12410
 $8.766.
Problem 9

(a) If the futures price of a commodity is greater than the spot price
during the delivery period, there is an arbitrage opportunity. Is
this true? If so, construct an appropriate strategy.

(b) If the futures price of a commodity is lower than the spot price
during the delivery period, there is an arbitrage opportunity. Is
this true? If so, construct an appropriate strategy.

Solution

a)Yes. In a perfect market, sell futures contract and buy the commodity. Then make
delivery. The futures price should equal spot price.

b)Perhaps, but not essential. In a perfect market, go long the futures contract, take
delivery and sell the commodity. The only problem is that the short may not deliver
immediately, while the sale is immediate. As the delivery period shrinks, however, the
spot and futures price will converge.
 Homework 2
FORWARD AND FUTURES PRICES

These problems cover the pricing of forwards and futures. Solve all the problems below.

Before you attempt these problems I would recommend that you read chapter 5 of Hull
and go through many of the problems in Hull ( problems 5.1 through 5.22). If you want
to borrow my study guide, which has solutions, please stop by Tedda Nathan’s office
( Room 371) and pick it up.

Question 1 (Hull)

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?

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

Question 2 (Hull)

A company that is uncertain about the exact date when it will pay or
receive a foreign currency may try to negotiate with its bank a forward contract
that specifies a period during which delivery can be made. The company wants to
reserve the right to choose the exact delivery date to fit in with its own cash flows.
Put yourself in the position of the bank. How would you price the product that
the company wants? ( Hint: The firm will choose the earliest possible date to
delivery if….., and the latest delivery date if…… So the bank will price the
product on the assumption that the firm chooses the delivery date (least? or most?
favorable to the bank)

Question 3 (Hull)

A trader owns gold as part of a long-term investment portfolio. The trader

can buy gold for $250 per ounce and sell gold for $249 per ounce. The trader can
borrow funds at 6% per year and invest funds at 5.5% per year. (Both interest
rates are expressed with annual compounding.) For what range of one-year
forward prices of gold does the trader have no arbitrage opportunities? Assume
that is no bid-offer spread for forward prices.
Question 4 (Hull)

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. ( Hint: This problem really requires you to
think carefully through all the steps. Be patient. It is tricky, until you see the
light!)