Question
Suppose the stock does not pay dividends. Denote the dates for today and the expiration date are 0 and T respectively. Denote the current spot
Suppose the stock does not pay dividends. Denote the dates for today and the expiration date are 0 and T respectively. Denote the current spot price of the stock as S', the spot price at the expiration date is S(, and the forward price for time T settlement signed today is F',(. Assume the risk-free interest rate is a known constant r. Answer the following questions: (a). What are the cash flows for buying a stock (and then hold it and sell it at T)? Show the cash flow tables. Show the payoff diagram. (4) (b). What is the replicating portfolio of buying a stock that consists of certain positions in forwards and risk-free bonds (or equivalently, risk-free borrowing or lending)? Show the cash flow tables. Show the payoff diagrams of your chosen positions of forwards and risk-free bonds respectively, and then show the payoff diagram of the replicating portfolio. (8) (c). What are the costs of the two strategies, respectively? (2) (d). Use the no-arbitrage principle to price the forward. (2)
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