MFIN6003 Derivative Securities Dr.

Huiyan Qiu

Session Three: In-Class Exercise on Forward Pricing Answers

❖ A $50 stock pays a 4% continuous dividend. The continuously compounded
risk-free rate is 6%.
➢ What is the price of a forward contract that expires 1 year from today?
Using the formula,
50e0.06-0.04 = 51.01

➢ Suppose you observe a one-year forward price of $52. What arbitrage

would you undertake?
Forward is priced too high → short forward.
At the same time, take synthetic long forward position:
borrow $50 e-0.04 and buy e-0.04 stock
Time T: Get $52 from forward position and return $50e -0.04e0.06
$52 – $50e-0.04e0.06 = $0.99
Profit: 0.99

➢ Suppose you observe a one-year forward price of $50. What arbitrage

would you undertake?
Forward is priced too low → long forward.
Take synthetic short forward position:
short sell e-0.04 stock and lend $50 e-0.04
Time T: Get $50e-0.04e0.06 and pay $50 for forward position
$50e-0.04e0.06 – $50 = $1.01
Profit: 1.01