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

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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
§੿ 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
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. 9/29/11 1.5

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Arbitrage and No-Arbitrage Arbitrage – Opportunity for a riskless profit* No-Arbitrage Hypothesis – There is never a scenario in which a selection of
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