Derivatives Example

Question 1 (3 marks)
Assume a perfect capital market. The current spot price of platinum is $1,700 per ounce. The
forward price for delivery of an ounce of platinum in one months time is $1,710. Assume
that storage costs of platinum are zero. Assume that the benefits of current ownership as
opposed to later ownership of platinum are also zero. The continuously compounded risk-free
rate is constant and is equal to 10% per year. You believe that platinum is overpriced and that
platinum prices will fall over the coming month. The size of the arbitrage profit per ounce of
platinum that you can achieve in one months time when rounded to two decimal places is:
(a) $10.00 by undertaking a cash and carry strategy
(b) $178.79 by undertaking a reverse cash and carry strategy
(c) Of unknown size and achieved by a strategy of shorting platinum
(d) $4.23 by undertaking a cash and carry strategy
(e) $4.23 by undertaking a reverse cash and carry strategy

Correct Forward Price = Spot + interest + storage costs benefits of ownership
=$1,700e
0.11/12
= $1,714.23.

Therefore forward is underpriced. Therefore undertake a reverse cash and carry strategy.
Buy the cheap forward contract and sell/short-sell the overpriced platinum and lend the
proceeds of the platinum sale.

Profit = $1, 700e
0.11/12
-$1,710 = $4.23.

Answer (e).