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# 2 sl - THE UNIVERSITY OF HONG KONG FACULTY OF BUSINESS AND...

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1 THE UNIVERSITY OF HONG KONG FACULTY OF BUSINESS AND ECONOMICS FINA0301CDE - DERIVATIVES First Semester, 2009-2010 Tutorial 1 Slide Chapter 2 - An Introduction to Forwards and Options c What is Arbitrage? Any trading strategy requiring no cash input that has some probability of making profits without any risk of loss. Law of one price: Two equivalent things cannot sell for different prices. Law of No Arbitrage (Analogy to price Derivatives): A portfolio involving zero risk, zero net investment and positive expected returns cannot exist. Types of Arbitrage: 1. Cash and Carry (Overview Lecture) 2. Parity Arbitrage (Chapter 9) 3. Spread Arbitrage (Chapter 9)

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FINA0301-Tutorial 1 Slide_______________________________________________________ Mr. Clive Man Chung HO 2 Cash and Carry Arbitrage (Overview Lecture: Slide 20-22) Arbitrage-free Forward Price: F 0 ,T = S 0 e rT -Suppose now: F 0 ,T > S 0 e rT -Effective interest rate: r; -Assuming no dividends and no transaction cost Proof of Arbitrage-free Forward Price: T=0 T=6 months Borrow Long Stock Short Forward TOTAL
FINA0301-Tutorial 1 Slide_______________________________________________________ Mr. Clive Man Chung HO 3 Reverse Cash and Carry Arbitrage (Overview Lecture: Slide 20-22) -Suppose now: F 0 ,T < S 0 e rT -Effective interest rate: r; -Assuming no dividends and no transaction cost Proof of Arbitrage-free Forward Price: T=0 T=6 months *Short-sell Stock Lend Long Forward TOTAL *Short-sell Stock: T 0 (Cash) Carry T T Borrow stock; and sell: S 0 (Short-selling proceeds) b ___________________________________________________ b Buy Back and Return: - S T If S T > S 0 : Gain/Loss If S T < S 0 : Gain/Loss

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2 sl - THE UNIVERSITY OF HONG KONG FACULTY OF BUSINESS AND...

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