Financial Risk Manager Part 1

Get started today

Ultimate access to all questions.

Explanation:

Explanation

The relationship between the forward price and spot price of an investment asset with no income and no applicable storage costs can be evaluated with the basic no-arbitrage formula:

$F = S(1 + R)^T$

Where:

$F$ = Forward price
$S$ = Spot price
$R$ = Risk-free interest rate
$T$ = Time to maturity

Given values:

Spot price $S = 24.70$
Forward price $F = 25.00$
Risk-free rate $R = 2\% = 0.02$
Time $T = 0.5$ years (6 months)

Calculate theoretical forward price: $F_{theoretical} = 24.70 \times (1 + 0.02)^{0.5} = 24.70 \times (1.02)^{0.5} = 24.70 \times 1.00995 = 24.95$

Comparison:

Actual forward price = 25.00
Theoretical forward price = 24.95

Since the actual forward price (25.00) is greater than the theoretical forward price (24.95), the forward contract is overpriced. This creates an arbitrage opportunity.

Arbitrage strategy:

Borrow money at the risk-free rate
Buy silver in the spot market at $24.70
Enter into a forward contract to sell silver at $25.00
At maturity, deliver the silver and receive $25.00
Repay the loan with interest: $24.95
Profit = $25.00 - $24.95 = $0.05 per ounce

Why other options are incorrect:

A: There IS an arbitrage opportunity since the forward is overpriced
B: Selling spot and buying forward would result in a loss
D: Buying spot and buying forward doesn't create an arbitrage position

The correct arbitrage strategy is to buy silver in the spot market and enter into a 6-month forward contract to sell silver (Option C).

Explanation:

Explanation

The relationship between the forward price and spot price of an investment asset with no income and no applicable storage costs can be evaluated with the basic no-arbitrage formula:

$F = S(1 + R)^T$

Where:

$F$ = Forward price
$S$ = Spot price
$R$ = Risk-free interest rate
$T$ = Time to maturity

Given values:

Spot price $S = 24.70$
Forward price $F = 25.00$
Risk-free rate $R = 2\% = 0.02$
Time $T = 0.5$ years (6 months)

Calculate theoretical forward price: $F_{theoretical} = 24.70 \times (1 + 0.02)^{0.5} = 24.70 \times (1.02)^{0.5} = 24.70 \times 1.00995 = 24.95$

Comparison:

Actual forward price = 25.00
Theoretical forward price = 24.95

Since the actual forward price (25.00) is greater than the theoretical forward price (24.95), the forward contract is overpriced. This creates an arbitrage opportunity.

Arbitrage strategy:

Borrow money at the risk-free rate
Buy silver in the spot market at $24.70
Enter into a forward contract to sell silver at $25.00
At maturity, deliver the silver and receive $25.00
Repay the loan with interest: $24.95
Profit = $25.00 - $24.95 = $0.05 per ounce

Why other options are incorrect:

A: There IS an arbitrage opportunity since the forward is overpriced
B: Selling spot and buying forward would result in a loss
D: Buying spot and buying forward doesn't create an arbitrage position

The correct arbitrage strategy is to buy silver in the spot market and enter into a 6-month forward contract to sell silver (Option C).

Comments (0)

No comments yet.

A portfolio manager at an investment fund specializing in trading precious metals is evaluating the current pricing conditions in the silver market. The manager observes that the spot price of silver is USD 24.70 per ounce and a 6-month forward contract is quoted at USD 25.00 per ounce. If the annually compounded risk-free interest rate is 2%, and assuming no lease rate, no storage costs, and no convenience yield, which of the following trades should the manager make to earn an arbitrage profit?

Real Exam

Community

LLeetQuiz

There is no arbitrage opportunity in the silver market.

9.1%

Sell silver in the spot market and enter into a 6-month forward contract to buy silver.

18.2%