Topic 2 Activities 1. What is the value of a futures contract at the time of purchase? Why is it this value?

How does this differ from the value of a spot price? When and under what conditions will forward and futures contracts be identical in price? You find out today that high-grade crude oil has a spot price of $5.5 per barrel and the corresponding futures contract price is $6.6 with an expiration date in three months time. If you know there is no risk premium in the futures market, why is the futures price higher than the spot price? The index on a futures contract is currently priced at $150. The futures contract has a life of 180 days, and during that time the stocks will pay dividends of $1 in 30 days, $0.85 in 90 days, and $0.50 in 120 days. The current risk free rate is 10% percent. a. Find the price of the futures contract assuming no arbitrage opportunities are present. Use discrete compounding. Joan Tam, CFA, believes she has identified an arbitrage opportunity for a commodity as indicated by the information given in Exhibit 1. Exhibit 1.
Spot price for commodity Futures price for commodity expiring in 1 year Interest rate for one year $120 $125 8.00%

2.

3.

4.

5.

A: Describe the transaction necessary to take advantage of this specific arbitrage opportunity. B: Calculate the arbitrage profit. C: Describe two market imperfections that could limit Tams ability to implement this arbitrage strategy.
Source: CFA Level 2 sample exam

Supplementary Question 1. Industrial Products Corp. (lPC), a publicly held company, is considering going private. It is extremely important to IPC's management that the pension fund's present surplus level be preserved pending completion of buyout financing. For the next three months (until September 1, 1990), management's goal is to sustain no loss of value in the pension fund portfolio. Today (June 1, 1990), this value is $300 million. Of this total, $150 million is invested in equities in the form of an S&P 500 Index fund, producing an annual dividend yield of 4 percent; the balance is invested in a single U.S. government bond issue, having a coupon of 8 percent and a maturity of 6/01/2005. Since the "no-loss strategy" has only a three-month time horizon, management does not wish to sell any of the present security holdings. Assume that sufficient cash is available to satisfy margin requirements, transaction costs, and so on, and that the following market conditions exist as of June 1, 1990: The S&P 500 Index is at the 350 level, with a yield of 4.0 percent. The U.S. government 8.0 percent bonds due 6/1/2005 are selling at 100. U.S. Treasury bills due on 9/1/90 are priced to yield 1.5 percent for the threemonth period (i.e. 6 percent annually). Available investment instruments are the following:
Contract S&P 500 Index future Future on U.S. government 8% bonds due 6/1/2005 S&P 500 call option S&P 500 put option U.S. government 8% due 6/1/2005 call option U.S. government 8% due 6/1/2005 put option Expiration 9/1/90 9/1/90 9/1/90 9/1/90 9/1/90 9/1/90 Current Contract Price $355.00 101.00 8.00 7.00 2.50 4.50 Strike Price 350 350 100 100 Contract Size $175,000 100,000 35,000 35,000 100,000 100,000

a) Assume that the management wishes to protect the portfolio against any losses (ignoring the costs of purchasing options or futures contracts) but wishes also to participate in any stock or bond market advances over the next three months. Using the preceding instruments, design two strategies to accomplish this goal, and calculate the number of contracts needed to implement each strategy.
CFA Examination Level III