MT3470/MT4570/MT5547: Solutions to Problem Set 1

1. What is the difference between a long forward position and a short forward position?
Solution. A trader who enters into a long forward position is agreeing to buy the underlying
asset for a certain price at a certain time in the future.
A trader who enters into a short forward position is agreeing to sell the underlying asset for a
certain price at a certain time in the future. [20]

2. An investor enters into a short cotton forward contract where the strike price is 50 pence per
kilo. The contract is for the delivery of 50 000 kilos. How much does the investor gain or lose
if the cotton price at the end of the contract is
(a) 48.20 pence per kilo
(b) 51.30 pence per kilo?
Solution.
(a) Gains (50 − 48.20) × 50000 pence, i.e. £900,
(b) Loses (51.30 − 50) × 50000 pence, i.e. £650.
[20]
3. Consider a six-month forward contract on a non-dividend paying stock when the spot price is
30 pounds and the risk-free interest rate with continuous compounding is 12% per annum.
a) Calculate the forward price.
b) Suppose that the delivery price in the contract is equal to the forward price, i.e. K = F0 ,
so that the value of the contract is equal to zero at the outset. What will be the value of the
contract (for the holder of the long position) and the forward price in three months, if the stock
price becomes equal to £34?
Solution.
a) The forward price is F0 = S(0)erT = 30e0.12·0.5 = 31.86 pounds.
b) The value of the long forward will be

f (0, t, T ) = S(t) − F0 e−r(T −t) = 34 − 31.86e−0.12·0.25 = 3.08.

If at time t = 0.25 (in three months) the underlying price is £34, then the corresponding
forward price will be
F (t, T ) = S(t)er(T −t) = 34e0.12·0.25 = 35.04.
[20]
4. Consider a one year forward contract on a stock with no income and storage costs, when the
spot price is S(0) = £50 and the risk-free interest rate with continuous compounding is r = 10%
per annum.
a) Calculate the forward price F0 .
b) Suppose a zero value forward contract with the same maturity and delivery price of F0 + £1,
is available on the same stock. Is there an arbitrage opportunity in this situation? If your
answer is yes, then describe an arbitrage strategy and, in particular, the risk-free profit.

1
c) Suppose a zero value forward contract with the same maturity and delivery price of F0 − £1,
is available on the same stock. Is there an arbitrage opportunity in this situation? If your
answer is yes, then describe an arbitrage strategy and, in particular, the risk-free profit.
Solution.
a) r = 0.1, T = 1, the forward price is F0 = S(0)erT = 50e0.1×1.0 = 55.2585.
b) In this case an arbitrager can borrow S(0) = 50 at 10% risk free for one year, buy the asset
and short the forward contract at time t = 0.
At maturity t = 1, they sell the asset for K = F0 + 1, pay back the loan plus the interest, that
is S(0)erT = F (0).
The amount left is £1 which is the risk free profit.
c) If the delivery price is K = F0 − £1, then the arbitrage strategy is as follows.
At time t = 0, short sell the asset, invest the proceeds S(0) = 50 at 10% risk free for one year
and take the long position in the forward contract.
At maturity t = 1, receive the amount S(0)erT = F (0) and buy the asset for K = F0 − 1
(fulfilling your obligations on the contract) and close out the short position in the asset.
The amount left is £1 which is the risk free profit. [40]

[Total mark 100]