Reading 51 - Forward Markets and Contracts Flashcards
Explain what the no-arbitrage principle is…..
That there should not be a riskless profit to be gained by a combination of a forward contract position with positions in other assets.
In simple terms,describe what a forward contract is….
An agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset or other derivative, at a future date at a price established at the start of the contract.
What are the 3 assumptions of the no-arbitrage principle?
- Transaction costs are zero
- There are no restrictions on short sales or on the use of short sale proceeds
- Both borrowing and lending can be done in unlimited amounts at the risk-free rate of interest.
What is the general formula for how to calculate the forward contract price?
***Ciritical Concept****
Consider a 3-month forward contract on a zero-coupon bond with a face value of $1,000 is currently quoted at $500, and the risk free annual interest rate of 6%. Determine the price of the forward contract under the no-abitrage principle……
In a cash and carry arbitrage, what should be done if the FRA is overpriced?
***Critical Concept*****
- Short (sell) the forward
- Long (buy) spot asset
- Borrow money
In a cash and carry arbitrage, what should be done if the FRA is underpriced?
****Critical Concept*****
- long (buy) the forward
- short (sell) the spot asset
- invest (lend) money
How is the value of a forward contract calculated at its initiation???
****Critical Concept******
How is the Long value of a forward contract calculated during the life of the contract???
****Critical Concept*****
How is the Short value of a forward contract calculated during the life of the contract ???
***Critical Concept****
How is the value of a forward contract calculated at maturity for both the long position and short position???
Long Position:
=St - FP
Short Position:
=FP - St
What adjustment do we need to make to calculate the price of an equity forward contract?
Since a stock, portfolio or equity index may have expected dividend payments over the life of the contract we have to account for these flows in one of two ways.
Calculate the no-arbitrage forward price for a 100 day forward on a stock that is currently priced at $30 and is expected to pay a $0.40 dividend in 15 days, $0.40 in 85 days and $0.50 in 175 days. The annual risk-free rate is 5%.
Ignore the dividend in 175 days because that occurs after the maturity of the contract.
How do you calculate the value of a long position in a forward contract on a dividend-paying stock?
***Critical Concept****
How do you calculate the price of an equity index forward contract whose dividends are paid continuously?
***Critical Concept****