A non-dividend paying stock recently closed at $86.25 You want to write a one-ye

Question

A non-dividend paying stock recently closed at $86.25 You want to write a one-year forward contract such that no money needs to change hands today. The risk free rate is 2.50% EAR.* You think the forward price (delivery price) should be 88.4063.

            Your friend thinks the delivery price is ridiculously low because both you and he believe the stock is expected to return 12.00% over the next year. He is willing to set the delivery price at $95.50 and he will not require any money to change hands (today).

            Outline a series of trades such that you make arbitrage profits.

Explanation / Answer

He wants to no change in cash position than he creat SELL & BUY position

He Write/Sell one year Buy Contract at 95.5 and Earn Brokerage( Contract price is lower than 96.6 than opposite party exsersice the contract)

And he earn 95.5-86.25=9.25

Now Sell Forward Contract(paid brokerage) at 88.4063 and buy at future(Close) 96.6 making loss = 8.1937

Net Earning 9.25-8.1937=1.0563 per share without change in cash

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