Lesson 2 Exercise 3: Pricing & Valuation (Don Chance page 44, Practice Problem 1)

An investor owns an asset valued at € 125.72. The investor plans to sell it in nine months to raise money, but he is concerned about the price risk. He took a short forward position on this asset with the delivery in 9 months. The risk-free interest rate is 5.625%.

1. What should be the amount the investor should be able to receive from such a forward contract in 9 months?
2. If the forward dealer quotes € 140, how can the investor take advantage of this? Annualized rate of return? Why the transaction is attractive?
3. Suppose you took the short position at the forward price computed in (A) above. Two months later, the spot price of the asset is € 118.875. What is the market value of your short position in the forward contract at this point?
4. What is the value of the forward contract at expiration assuming the contract is entered into at the price computed in (A) above? The spot price of the asset is € 123.50 at expiration. Explain how the investor did on the overall position of both the asset and the forward contract in terms of the rate of return.

This exercise provides you with an opportunity to review some concepts of forward contracts on an underlying asset with no income, no storage cost. Please attempt to solve the question on your own and then check the answers in the textbook. Finally, please submit your work to the Lesson 2: Exercise 3 Drop Box to retrieve the Excel solution. The Excel solution is a locked file and can only be accessed once you have submitted your work to the Lesson 2: Exercise 3 Drop Box. Note: The cells which are highlighted yellow within the Excel worksheet are input data.

Review your answers in comparison to the solution. If you have wrong answers to the question, you should revisit the forward contracts concepts presented. And, if you still have difficulties understanding the material and why you made mistakes, please contact me.