RMSC 4001 Assignment 1 Suggested Solution

ZhilingGU@link.cuhk.edu.hk

Question 1 (15 pts)

(a) What are the forward price and the initial value of the forward contract?

Note that strike K, is set to equal F0 in order to make forward value at the initial time to
be zero. That means neither the long party nor the short party need to make any payment
when the contract initiates. This makes things convenient.

Forward value:
ft = St − Ke−r(T −t)
ft = St − Ke−r(T −t) ≡ 0
⇒ Ft = St er(T −t)
Note that forward price at time t is recognized as strike price of a forward from time t to
maturity T, with time to maturity (T − t). Calculation is carried out to make ft = 0 Foward
price:
f0 = S0 − Ke−r(T −0) ≡ 0 (Initial value) 
⇒ F0 = K = S0 er(T −0)
= 40e0.05×1 ≈ 42.0508 (Foward price) 
(b)Six months later, the price of the stock is $45 and the risk-free intereste
rate is still 5%. What are the forward price and the forward value of the contract?

Forward value:
ft = St − Ke−r(T −t)
= 45 − 42.0508e−0.05(1−6/12)
≈ 3.9874 
Foward price:
Ft = St er(T −t)
= 45e0.05(1−6/12)
≈ 46.1392 

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 Question 2 (15 pts)

Assume domestic risk free interest rate is rd , foreign risk free interest rate is rf (can be
viewed as dividend). Both interest rate are in continuously compounding form.The idea is
to calculate K2 such that the value of new forward at time T1 resembles the value
of the old forward that is going to expire at T1 .

Forward value of the expiring forward at T1 :

ftold = St e−rf (T1 −t) − K1 e−rd (T1 −t)

⇒ K1 = F0 = S0 e(rd −rf )T1
fTold
1
= S1 e−rf (T1 −T1 ) − K1 e−rf (T1 −T1 )
= S1 − K1
= S1 − S0 e(rd −rf )T1

Forward value of the new forward at T1 :

ftnew = St e−rf (T2 −t) − K2 e−rd (T2 −t)

fTnew
1
= S1 e−rf (T2 −T1 ) − K2 e−rd (T2 −T1 ) ≡ fTold
1

⇒ K2 = S1 e(rd −rf )×(T2 −T1 ) − (S1 − K1 )erd (T2 −T1 ) 

When rf equals zero, K2 = S1 erd (T2 −T1 ) − (S1 − K1 )erd (T2 −T1 ) = S0 erd (T2 −T0 ) .

Question 3 (30 pts)

(a)What are the no arbitrage pricing formulas for f (t, S) and Ft ?

Let P0 to be the portfolio that longs 1 unit two-tenor ES, then the value of P0 at time t
can be regarded as the sum of two forward value when neither tenor has been reached, and
a single-tenor forward when the first tenor has been reached, i.e.
(
f1 (t) + f2 (t), if 0 6 t 6 T1 .
f (t) = Π0 (t) =
f2 (t), if T1 < t 6 T2 .
where f1 (t) = St − Ke−r(T1 −t) , f2 (t) = St − Ke−r(T 2−t) 

On the other hand, we can also construct a replicating portfolio with same payment at
time T2 to calculate the no-arbitrage price of P0 .

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 Table 1: Cash flow of longing 1 unit of two-tenor ES
Time T1 T2
Long 1 two-tenor ES Pay $K, Receive 1 unit S1 Pay $K, Receive 1 unit S2
Hold ES since t 6 T1 −K + S1 + f2 (T1 ), −Ker(T2 −T1 ) + S2 − K + S2
Hold ES since T1 < t 6 T2 −Ker(T2 −T1 ) + S2 as t ↓ T1 −K + S2

• When 0 6 t 6 T1

Consider a portfolio P1 at time 0: (i) Long 2 units underlying S0 , (ii) Borrow $Ke−rT1
for T1 , $Ke−rT2 for T2 in risk free investment ⇒ the value of P1 at time t, Π1 (t) = 2St −
Ke−r(T1 −t) − Ke−r(T2 −t) , and Π1 (T2 ) = 2S2 − Ker(T2 −T1 ) − K ≡ f (T2 ) obviously. Therefore,
Π1 (t) ≡ f (t) for 0 6 t < T1 .

• When T1 < t 6 T2

Consider a portfolio P1 at time T1 : (i) Long 1 units underlying St , (ii) Borrow $Ke−rT2
for T2 in risk free investment ⇒ the value of P1 at time t, Π1 (t) = St − Ke−r(T 2−t) , and
Π1 (T2 ) = S2 − Ker(T2 −T1 ) − K ≡ f (T2 ) obviously. Therefore, Π1 (t) ≡ f (t) for t0 6 t 6 T2
with T1 < t 6 T2 .
(
2St − Ke−r(T1 −t) − Ke−r(T 2−t) , if 0 6 t 6 T1
Therefore, f (t) = Π0 (t) ≡ Π1 (t) =
St − Ke−r(T 2−t) , if T1 < t 6 T2
where K = F (0) = 2S0 /(er(−T1 ) + er(−T2 ) ) 

Setting f (t) to be zero, we get Ft :

(
2St /(e−r(T1 −t) + e−r(T2 −t) ), if 0 6 t 6 T1
F (t) =
St /(e−r(T 2−t) ), if T1 < t 6 T2 

z Remark: forward price of multiple-tenor ES is no longer relevant to historical tenors,

but only future tenors.

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 (b)
T1 = 3/12
T2 =1
r = 0.03
S0 = 10
K = F (0) = 2S0 /(e−r(T1 −0) + e−r(T 2−0) )
= 2 × 10/(e−0.03×0.25 + e−0.03×1 )
≈ 10.1886 

(c) What is the no-arbitrage pricing for an n-tenor ES? The n-tenor ES has
n transaction dates at T1 < T2 < ... < Tn .

For t ∈ (Ti , Ti+1 ], there are (n − (i + 1) + 1) = (n − i) tenors that has not been met.
Therefore, the value of ES equal to the sum of these (n − i) foward values, i.e.

n
X n
X
f (t) = fj (t) = (n − i)St − Ke−r(Tj −t)
j=i+1 j=i+1

f (t) ≡ 0
n
X
⇒ K = (n − i)St / e−r(Tj −t) 
j=i+1

Incorporate the information of t in the equation we have


nSt / nj=1 e−r(Tj −t) ,
P

 if t = 0



P
n−1
I(Ti ,Ti+1 ] (t) × (n − i)St / nj=i+1 e−r(Tj −t) , if 0 < t 6 Tn
P
F (t) = i=0





N/A, if t > Tn 


z Remark 1: Here we treat t = Ti as the time when the i − th tenor has not been met.
You can also regard t = Ti as the time when the i − th tenor has been met. In that case, the
indicator function in the equation above would be I[Ti ,Ti+1 ) (t), and Tn should be identified
separately.
(
1, if x ∈ A
z Remark 2: Indicator function IA (x) =
0, if x ∈/A

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 Question 4 (20 pts)

Note that between July 31 and December 31, the index has dividend 5% for 2 months, and
2 3
2% for 3 months. Construct a replicating portfolio P at time T by: (i) Long e−(0.05× 12 +0.02× 12 )
5
units of underlying index (ii) Borrow Ke−r× 12 in risk free investment. Then the value of port-
folio P at time T (December 31) is
2 3 2 3 5 5
Π(T ) = ST e−(0.05× 12 +0.02× 12 ) × e(0.05× 12 +0.02× 12 ) − Ke−r× 12 × er× 12 = ST − K = f (T )

By no-arbitrage theorem, value of portfolio Π(t) must equal to f (t) for any t such that
0 6 t 6 T . Therefore,

f (0) = Π(0)
2 3 5
= S0 e−(0.05× 12 +0.02× 12 ) − Ke−r× 12
To price K, we let f (0) ≡ 0
2 3 5
⇒ F (0) = K = S0 e−(0.05× 12 +0.02× 12 ) × er× 12
2 3 5
= S0 e−(0.05× 12 +0.02× 12 +r× 12
2 3 5
= 300 × e−(0.05× 12 +0.02× 12 )+0.03× 12
≈ 299.7501 

z Remark: Dividends are continuously compounding.

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 Question 5 (20 pts)
1 f oreign
At time τ ∈ [T1 , T2 ], Company  Bank
K domestic

For the company, it needs to prepare 1 unit of foreign currency for payments to others,
but does not know when the payment will take place. Therefore, the company enters such
a contract that during a period, say [T1 , T2 ], the company can choose any date to pay K
domestic currency to get 1 foreign currency. Apart from the consideration of actual need of
foreign currency, the company would certainly consider the value of the contract, and try to
exercise the contract at the time when the company can realize the maximum value out of
this contract.

On the other hand, the bank would want to make sure that, the value of the contract to
the bank would always be above or equal to zero, i.e. the minimum value should be larger
or equal to zero. If there exist a certain time point τ ∗ ∈ [T1 , T2 ], contract value is negative
to the bank and positive to the company, then the company would always decide to exercise
at τ ∗ and an arbitrage arises. (Recall that the value of the contract to the company equal to
the negation of the value to the bank.)

We can therefore get the sense that, maximum value of contract to the company = -
minimum value of the contract to the bank = 0 is the pricing foundation.

To compare the effect on contract value of different deliverty time τ , we need to choose
a comparison reference time, i.e. according to some specified time, value of the contract is
comparible. Simple comparison of payoff/ strike is meaningless.

z Remark: Interest rate parity

Consider two investments: (i) Invest 1 domestic currency (DOM) in domestic risk free
rate rd from now T0 until time T (ii) Transfer 1 (DOM) to foreign currency (FOR) at current
1
time T0 , invest these F X 0
(FOR) in foreign risk free rate rf , and transfer the investment to
(DOM) at time T .

In complete market, these two investment should produce the same return, i.e.

1 × erd T = 1
F X0
× erf T × F XT ⇒ F XT = F X0 e(rd −rf )T 

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 • For the bank

Contract value at time τ : f b (τ ) = −1 × F Xτ + K = −F X0 e(rd −rf )τ + K , τ ∈ [T1 , T2 ]

Foreign exchange rate at time τ : FXτ , i.e. 1 (FOR) = F Xτ (DOM)

Discounted value of f b (τ ) at time T0 : f0b (τ ) = f b (τ )e−rd τ = −F X0 e−rf τ + Ke−rd τ

Minimum of discounted contract value to the bank when choosing different τ ∈ [T1 , T2 ]:

min f0b (τ ) = min (−F X0 e−rf τ + Ke−rd τ ) ≡ 0 (No-Arbitrage)

τ ∈[T1 ,T2 ] τ ∈[T1 ,T2 ]

min (−F X0 e−rf τ + Ke−rd τ ) × erd τ = 0

τ ∈[T1 ,T2 ]

min [(−F X0 e−rf τ + Ke−rd τ ) × erd τ ] = 0

τ ∈[T1 ,T2 ]

min (−F X0 e(rd −rf )τ + K) = 0

τ ∈[T1 ,T2 ]

min (−F X0 e(rd −rf )τ ) + K = 0

τ ∈[T1 ,T2 ]

− max (F X0 e(rd −rf )τ ) + K = 0

τ ∈[T1 ,T2 ]

⇒ K = max (F X0 e(rd −rf )τ )

τ ∈[T1 ,T2 ]

Therefore,

F X0 e(rd −rf )T1 ,



 if rd < rf
F X e(rd −rf )T2 ,

if rd > rf
0
K=
F X0 ,
 if rd = rf


U nidentif iable, if rd , rf has uncertain relationship 

• For the company

Contract value at time τ : f c (τ ) = 1 × F Xτ − K = −f b (τ ) , τ ∈ [T1 , T2 ]

Similar process to the bank. The only difference lies in maximum, instead of minimum,
of the discounted contract value to the company is set to zero.

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