Question
Eric enters into a six-month long forward contract on a non-dividend-paying stock when the stock price is $40 and the risk-free rate of interest is
Eric enters into a six-month long forward contract on a non-dividend-paying stock when the stock price is $40 and the risk-free rate of interest is 5% per annum with continuous compounding.
(a) What are the forward price and the initial value of the forward contract to Eric? (5 marks)
(b) Three months later, the price of the stock becomes $35 and the risk-free interest rate is 6% with continuous compounding. What are the forward price and the value of the forward contract to Eric? (6 marks)
(c) Assume that the forward price is $42 when the forward is entered (six months before maturity). Is there an arbitrage opportunity? Show in detail how we can earn a profit. How much is this profit per stock? (10 marks)
(d) How would your answer from (a) change if the stock is expected to pay a dividend of $1.5 in nine months? (2 marks)
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