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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)

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fortuneonyemuwa

Answer:

Explanation:

Price of forward should be = spot rate × (1 + foreign interest rate)/(1 + domestic interest rate) =[tex]40 \times(\frac{1+0.05}{1+3})=40.5000[/tex]

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

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