PPT 1 - 1.1 1. FORWARD CONTRACTS Reading: Luenberger...

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9/29/11 1. FORWARD CONTRACTS Reading: Luenberger Chapter 10 Prerequisite: Interest rates. Read (review) Luenberger Chapter 4. 1.1
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§ A Forward Contract is an agreement between two parties to buy/sell an asset at an agreed upon price at an agreed upon time in the future . – Long position : agrees to buy the asset – Short position : agrees to sell the asset – Spot price : price of the asset today – Delivery price : price agreed upon in forward contract. Example: Buy 100,000 pounds of sugar at 12 cents per pound one year from today . The buyer is long 100,000 pounds; the seller is short 100,000 pounds. 12 cents is the delivery price or sometimes called the forward price F. Question: Is F=12 cents a fair price if the spot price is 10 cents ? 1.1 Forward Contracts 9/29/11 1.2
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§ Example : Suppose the interest rate is 5% and the spot price of oil is $100/barrel. An oil refiner enters into a forward contract to purchase 1000 barrels of oil to be delivered in one year. § Assume no storage costs for the asset 9/29/11 1.3
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What if the delivery price is $110? One trading strategy is: § Borrow $100,000 today for one year at 5% interest. § Purchase today 1000 barrels of oil, and store them for one year. § Enter into a short forward contract to sell the oil for $110,000 in one year. § After one year the trader sells the oil for $110,000, repays the loan (principle and interest) for $105,000, and makes a $5,000 profit. – A sure future profit without any investment! 9/29/11 1.4
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What if the delivery price is $90? One trading strategy for a market participant who owns oil is: § Sell 1000 barrels of oil today, for $100,000. § Invest the $100,000 at 5% interest. § Enter into a long forward contract today to purchase the oil for $90,000 in one year. § After one year the trader has $105,000, uses $90,000 to repurchase the oil, and is left with a $15,000 The preceding two trading strategies are examples of arbitrage , a trade that takes advantage of the relative mis- pricing of two or more assets. An arbitrage opportunity is a trade that locks in a risk free profit.
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This note was uploaded on 03/23/2012 for the course AMATH 541 taught by Professor Kk.t during the Winter '11 term at University of Washington.

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PPT 1 - 1.1 1. FORWARD CONTRACTS Reading: Luenberger...

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