What should a trader do when they believe the one-year forward price of an asset is lower than its intrinsic value? Assume that the asset provides no income. The trader should borrow the price of the asset, buy one unit of the asset and enter into a short forward contract to sell the asset in one year.The trader should borrow the price of the asset, buy one unit of the asset and enter into a long forward contract to buy the asset in one year. The trader should short the asset, invest the proceeds of the short sale at the risk-free rate, enter into a short forward contract to sell the asset in one year. The trader should short the asset, invest the proceeds of the short sale at the risk-free rate, enter into a long forward contract to buy the asset in one year.
Question
What should a trader do when they believe the one-year forward price of an asset is lower than its intrinsic value? Assume that the asset provides no income. The trader should borrow the price of the asset, buy one unit of the asset and enter into a short forward contract to sell the asset in one year.The trader should borrow the price of the asset, buy one unit of the asset and enter into a long forward contract to buy the asset in one year. The trader should short the asset, invest the proceeds of the short sale at the risk-free rate, enter into a short forward contract to sell the asset in one year. The trader should short the asset, invest the proceeds of the short sale at the risk-free rate, enter into a long forward contract to buy the asset in one year.
Solution 1
If a trader believes that the one-year forward price of an asset is lower than its intrinsic value, they would expect the asset's price to rise. In this case, they would want to profit from the expected increase in the asset's price.
To do this, the trader should borrow the price of the asset, buy one unit of the asset, and enter into a long forward contract to buy the asset in one year. This way, they can sell the asset at the higher intrinsic value in the future, repay the borrowed amount, and keep the difference as profit.
Therefore, the correct answer is:
B. The trader should borrow the price of the asset, buy one unit of the asset and enter into a long forward contract to buy the asset in one year.
Solution 2
If a trader believes that the one-year forward price of an asset is lower than its intrinsic value, they would expect the asset's price to rise in the future. In this case, the trader would want to lock in the ability to sell the asset at a higher price in the future.
To do this, the trader should borrow the price of the asset, buy one unit of the asset, and enter into a long forward contract to sell the asset in one year. This way, the trader can sell the asset at the higher intrinsic value in the future, regardless of the actual market price at that time.
Therefore, the correct answer is A. The trader should borrow the price of the asset, buy one unit of the asset and enter into a short forward contract to sell the asset in one year.
Similar Questions
1. What should a trader do when the one-year forward price of an asset is too low?Assume that the asset provides no income:A. The trader should borrow the price of the asset, buy one unit of the asset and enter intoa short forward contract to sell the asset in one yearB. The trader should borrow the price of the asset, buy one unit of the asset and enter intoa long forward contract to buy the asset in one yearC. The trader should short the asset, invest the proceeds of the short sale at the risk-free rate,enter into a long forward contract to buy the asset in one yearD. The trader should short the asset, invest the proceeds of the short sale at the risk-freerate, enter into a short forward contract to sell the asset in one year
Which of the following is TRUE about a short forward contract position? Select one alternative The short position is worth zero if the price of the asset declines after the contract has been entered into. The short position becomes more valuable as the price of the asset rises. The short position is worth zero if the price of the asset rises after the contract has been entered into. The short position becomes more valuable as the price of the asset declines.
A one-year forward contract is an agreement where: A. One side has the obligation to buy an asset for a certain price at some time during the next year. B. One side has the obligation to buy an asset for the market price in one year’s time. C. One side has the obligation to buy an asset for a certain price in one year’s time. D. One side has the right to buy an asset for a certain price in one year’s time.
Consider a long position in a two-years forward contract. The underlying asset is gold which incurs a net storage and security cost of 2% p.a., continuously compounded. The total value of the underlying gold today is $100 million. The risk-free rate of interest is 6.09% p.a. with semi-annual compounding for all maturities. Answer the following questions: (1) What are the forward price and the initial value of this forward contract? (2) One year later, the value of the gold is $120 million and the risk-free rate of interest remains the same. The net storage and security cost also remains the same. What are the forward price and the value of the forward contract?
Which of the following is TRUE:Group of answer choicesNone of the above.A short position in a forward contract gives you the right and the obligation to buy an asset at a specified price, at a specified time in the future.Only the counterparty, which is short futures, is required to deposit money in a margin account.A long forward contract is equivalent to a long position in a put option and a short position in a call option.Buying an option to sell is the same as selling an option to buy.
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