Question 1 (from 2010 session 1 Exam) [10 marks] Suppose that the current price of wheat is $5 per bale. The forward price, for purchase of wheat in three months' time, is $5.80 per bale. Storage costs for wheat are $0.50 per bale for 3 months payable after 3 months. Assume j12 = 12% p.a. and the forward contract is on 1,000 bales of wheat.

By using two carefully labelled cash flow diagrams in your answer setting out the cash flows associated with the forward contract and the replicating portfolio, explain how you can determine the fair forward price for this forward contract. Base your answer on the arbitrage pricing principle, and give your answer in dollars rounded to six decimal places.

List and explain all the steps that a person needs to take in order to make an arbitrage profit from buying or selling such a forward contract on 1,000 bales of wheat, including any associated borrowing or lending. Make sure you outline all that needs to happen on all relevant dates, as well as today. Calculate the arbitrage profit and give your answer in dollars rounded to three decimal places.