Question

Consider a long forward contract to purchase a non-dividend-paying stock in 3 months. Assume the current stock price is $40 and the risk-free interest rate is an APR of 5% compounded quarterly. If the market forward price is $43, show explicitly the arbitrage opportunity.

note: this is not continuous compounding but discrete! so please do not use the Se^(rT) ( exponential formula)

Answer 1

Step-by-step explanation:

Price of forward should be = spot rate × (1 + foreign interest rate)/(1 + domestic interest rate) =
`40 *((1+0.05)/(1+3))=40.5000`

As market price is greater, sell forward and borrow money to buy the asset at spot

t=0:

Borrow 40

Buy Spot

Sell forward

t=3 months:

Return 40.5

Get 43 from forward