Economics 251 Homework 2

Due Monday, May 1st, 2017 at 5.00 p.m.

Please follow these instructions:

Please write your answers in the space provided on this sheet (but please dont
hand in the tables at the end).

name :
Please write your name and student ID number here:
student ID :
You can work in groups of up to 5 students and hand a common answer sheet.

Use continuous compounding throughout.

Please submit a hard copy to Fabrice Tourre at the beginning of the TA session
and email me directly any clarifying question.

Currency forwards with bid-ask spreads. Table 1 and Table 2 contain relevant data on
interest rates and exchange rates on April 8, 2009. The tables contain bid and ask prices (i.e.,
borrowing and saving interest rates). We want to compute the implied forward 3-months exchange
rate of the Euro vs. the US Dollar, to buy Euros against Dollars in 3 months. Because of bid-ask
spreads, we will determine a band of forward rates that are compatible with no arbitrage.

1. What is the maximum forward exchange rate such that you would make a sure profit by
taking a long position in this contract? What is the profit-making portfolio in case theres
an arbitrage opportunity? Please give 4 digit accuracy.

2. What is the minimum forward exchange rate such that you would make a sure profit by
taking a short position in this contract? What is the profit-making portfolio in case theres
an arbitrage opportunity? Please give 4 digit accuracy.

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 3. Please conclude: what is the band of forward rates?

Forwards on stocks with dividends. Lets price a forward on the Dow Jones Industrial
Average stock index (DJIA) for July 8, 2009. We consider using the 3-month interest rates to
discount payoffs. In addition to the bid-ask spread on the interest rate, you also have to consider
transaction costs: your broker requires $2 per unit of the index he trades on your account. On
April 8, 2009, the DJIA opened at 7,839.89.
1. Abstracting from bid-ask spreads and transaction costs, suppose the price of the July for-
ward of the DJIA opened at exactly 7,858.5 on April 8. Please infer the dividend yield q
(continuously compounded) on the DJIA. For this question only, assume that rU S = 2.95%.

2. Now we reintroduce bid-ask spreads and transaction costs, and use the dividend yield q we
found in (a). Given that the interest rates for saving and borrowing are those given in next
pages tables (the same as for question 1), and given that your broker charges $2 per unit
of the index you trade (be it to give it or take it from the broker), please find the lower and
upper bound on the price of the 3-months DJIA forward such that you cant exploit any
arbitrage opportunity (use the same method as for question 1). You dont need to give any
decimal for this question.

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Commodity forwards with storage costs. Suppose you are an American commodity arbi-
trageur on the NYMEX: you can buy oil barrels and store them at some cost, however you cannot
short them. On April 9, 2009, the NYMEX crude oil barrel traded at $52.24. For what values of
the 3-months forward would you find an arbitrage? The interest rates are the same as for question
1 and 2, and the storage costs are 1% of the value of the asset.

Apr 8, 2009 Short Term 7-day notice 1 month 3 months 6 months 1 year
(borrow) (save) (borrow) (save) (borrow) (save) (borrow) (save) (borrow) (save) (borrow) (save)

Euro 1.2 0.7 0.89 0.79 1.13 1.07 1.74 1.44 1.65 1.5 1.82 1.67
Sterling 0.67 0.35 0.76 0.35 1.07 0.75 1.35 1.30 1.51 1.46 1.81 1.73
Swiss Franc 0.60 0.02 0.47 0.07 0.29 0.17 0.72 0.66 0.85 0.80 0.90 0.84
Canadian dollar 0.29 0.09 0.85 0.60 0.77 0.70 1.07 1.01 1.48 1.41 2.09 2.02
US dollar 0.25 0.15 0.49 0.42 0.83 0.80 1.36 1.34 1.83 1.76 2.56 2.50
Japanese Yen 0.33 0.01 0.26 0.11 0.38 0.29 0.79 0.74 0.96 0.75 0.99 0.94

Table 1: Interest Rates (bid and ask prices). Source: Reuters.

Apr 8, 2009 US dollars

Canada C$ 0.808
Denmark Dkr 0.178
Euro Euro 1.323
Japan Y 0.010
Switzerland SFr 0.871
UK Pound 1.464

Table 2: Exchange Rates. Price in US dollars for each currency (i.e., 1 Euro costs 1.323 US
dollars). Source: Reuters.

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 Futures and Margin Call. A company enters into a short futures contract to sell 5,000
bushels of corn for 200 cents per bushel. The initial margin is $3,000 and the maintenance margin
is $2,000. What price change would lead to a margin call?.

Forward Price of a Stock. A one-year-long forward contract on a non-dividend-paying

stock is entered into when the stock price is $50 and the risk-free interest rate is 5% per annum
with continuous compounding.

1. What are the forward price and the initial value of the forward contract?.

2. Six months after the signing of the forward contract, the price of the stock is $55 and the
risk-free interest rate is still 5%. What is the new market forward price for the same contract
(which will now mature in 6 months)? What is the value of the forward contract signed 6
months ago?

Forward Price of a Stock that Pays a Discrete Dividend. Prove by a non-arbitrage

argument that if a stock pays a one-time discrete known dividend D (per share) at time T1 < T ,
the forward price of a forward contract with maturity at T should be:

F0,T = (S0 P V (D)) erT

where P V (D) is the present value at time 0, of the dividend payment that occurs at time T1 .
Although you can do this just with the information I have given you, you can do this using the

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following numbers if it is easier for you. The stock is IBM, it is trading at $100. IBM will pay a
$1 dividend per share in 3 months. The interest rate is 4% per annum continuously compounded
and the forward contract has a 6-month maturity.