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
Question
- 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
Solution
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.
Here's why:
If the one-year forward price of an asset is too low, it means that the future price of the asset is expected to be lower than the current price. In this case, the trader can take advantage of this situation by borrowing money to buy the asset now and agreeing to sell it in the future at the forward price. This is known as a short forward contract.
By doing this, the trader is essentially locking in a profit. They are buying the asset at a lower price now and agreeing to sell it at a higher price in the future. This strategy is known as "cash and carry" arbitrage.
The other options (B, C, and D) are not correct because they involve either buying the asset in the future (long forward contract) or selling the asset now (shorting the asset), both of which would not be profitable if the forward price is too low.
Similar Questions
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.
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.
A stock is currently priced at $40. The risk-free rate of interest is 8% p.a. compounded continuously and an 18-month maturity forward contract is currently traded in the market at $43. You suspect an arbitrage opportunity exists. Which one of the following transactions do you need to undertake at time t = 0 to arbitrage based on the given information? a) Long the forward, borrow money and buy the share b) Short the forward, short-sell the share and invest at risk-free rate c) Long the forward, short-sell the share and invest at risk-free rate d) Short the forward, borrow money and buy the share
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?
A twelve-month short forward contract on a dividend-paying stock is entered into when the stock price is 133 and this stock is expected to pay a dividend of 5 in seven months. In addition, the risk-free rate of interest is 7.13% 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) Nine months later, the price of the stock is $152 and the risk-free rate of interest remains the same. What are the forward price and the value of the forward contract?
Upgrade your grade with Knowee
Get personalized homework help. Review tough concepts in more detail, or go deeper into your topic by exploring other relevant questions.