a. Consider a forward contract on a financial asset (which does not pay dividends) with a 1 year maturity. The delivery price of the forward contract is $50 and the current asset price is $49. Explain how the forward contract can be used to speculate on the value of the underlying. (5 marks) b. A manufacturing firm wishes to hedge its purchase of 10,000 units of a particular raw material 8 months from now. The current spot price of the material is $345 per unit and the continuously compounded interest rate is 5%. A futures contract with 9 months to maturity exists on this raw material. Each future has a contract size equal to one unit of the underlying asset. How would the firm use this future to hedge? Assuming no storage costs or convenience yields, work out the price at which the firm enters into the futures contract today. If, 8 months later, the spot price of the raw material is $420 per unit, work out the profit and loss on the hedge and the total effective cost of the purchase. Thus, what is the effective price that the firm pays per unit for the raw material? (12 marks) c. A non-dividend paying financial asset has a price of $200 and a oneyear future on this asset has price equal to $215. If the continuously compounded rate of interest is 3%, show that one can make an arbitrage profit and design a strategy to earn that profit. (10 marks) d. What is 'basis' and what is 'basis risk' within the context of futures hedging. Briefly discuss what might cause basis and basis risk to be large or small. (8 marks)