Forward Pricing Essay

514 words - 3 pages

Part 2 - Homework Problem(s) - Complete the problem(s) below and submit to me in word, excel, or pdf format to be graded (worth 10 points per week).  The homework problems should be submitted by Midnight CT on Sunday of Week 3.
Problem 5.32.
A trader owns a commodity as part of a long-term investment portfolio. The trader can buy the commodity for $950 per ounce and sell it for $949 per ounce. The trader can borrow funds at 6% per year and invest funds at 5.5% per year. (Both interest rates are expressed with annual compounding.) For what range of one-year forward prices does the trader have no arbitrage opportunities? Assume there is no bid–offer spread for forward prices.

Utilizing the ...view middle of the document...

5% and then enter into a forward contract to repurchase the gold for Fo. The profit for this venture is just the reverse of the equation used above, where $949e(0.055)(1) – Fo = $1002. Therefore so this venture would only be profitable if Fo is less than $1002.
Therefore our no arbitrage window is $1008 < Fo < $1002. Simply put if the forward price is between $1008 and $1002 there is no arbitrate opportunity.
The listed solution to the problem did not use the given equation in the book, and so listed a slightly different no arbitrage window of $1007 and $1001. I used the book equation since that was what our weeks lesson was on.
 
Problem 3.23
Sixty futures contracts are used to hedge an exposure to the price of silver. Each futures contract is on 5,000 ounces of silver. At the time the hedge is closed out, the basis is $0.20 per ounce. What is the effect of the basis on the hedger’s financial position if (a) the trader is hedging the purchase of silver and (b) the trader is hedging the sale of silver?

A) The Long Hedge position: if the basis strengthens then the company’s position will worsen, and they will need to pay a higher price for the asset. Conversely, if the basis weakens (decreases) then the company’s position will improve.

B) The Short Hedge position: if the basis strengthens, then the company’s position is strengthened, but if the basis weakens, then the company’s position will worsen. Basically, this is the exact opposite of the Long Hedge position.

Overall, since they have hedged 300,000 ounces of Silver, the basis effect on their position is $3000 for every cent that the basis rises or falls.

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