Question 4 (Past Exam)

(a) Identify the fundamental difference between a futures contract and an option contract, and briefly explain the
difference between the ways that they modify portfolio risk.
(3 marks)
(b)The ASX200 portfolio pays a dividend yield of 2% per annum and its current value is 6,000. The risk free rate is
4%. The ASX200 futures price for delivery in one year is 6,100. Construct an arbitrage to exploit the mispricing
and show that your profits in one year will equal the mispricing in the futures contract.
(5 marks)

(c) The SFE has just introduced a futures contract on shares in Battery Company Limited (ASX: BAT). BAT currently
pays no dividends. Each futures contract is for delivery of 1,000 shares in BAT in one year, the risk free rate is
4% and the BAT share price is currently $20. Answer the following questions:
i. What should the futures price be?

ii. BAT makes an announcement that their first dividend of $2 will be paid in six months. What should the
futures price be?

(3 marks)

(d)Assume that the spot price of the euro to Australian dollar is $1.40. If the one year forward price is $1.41, and
the one year interest rate in Australia is 3%, what is the interest rate in Europe?
(3 marks)
(Total 14 marks)

Q4
Solutions
a) The important distinction between a futures contract and an options contract is that the futures contract is an obligation. When an investor
purchases or sells a futures contract, the investor has an obligation to either accept or deliver, respectively, the underlying commodity on the
 expiration date. In contrast, the buyer of an option contract is not obligated to accept or deliver the underlying commodity but instead has the
right, or choice, to accept delivery (for call holders) or make delivery (for put holders) of the underlying commodity anytime during the life
of the contract.
Futures and options modify a portfolios risk in different ways. Buying or selling a futures contract affects a portfolios upside risk and
downside risk by a similar magnitude. This is commonly referred to as symmetrical impact. On the other hand, the addition of a call or put
option to a portfolio does not affect a portfolios upside risk and downside risk to a similar magnitude. Unlike futures contracts, the impact of
options on the risk profile of a portfolio is asymmetric.

b) The parity value of F is: 6000 (1 + 0.04 0.02) = 6,120

The actual futures price is 6,100, too low by 20.

Arbitrage Portfolio CF now CF in 1 year

Short index 6,000 ST (0.02 6,000)
Buy futures 0 ST 6,100
Lend 6,000 6,000 1.04
Total 0 20
Which is the difference in mispricing.

c)

i. 20x1.04 = $20.80
ii. Subtract future value of dividends = 2x(1.04)0.5 = 2.04 so price = $18.76.
 F0 S0
1 rAUS
1 rEURO
d) Therefore, r = (1.4x1.03)/1.41 1 = 2.27%
 Question on Forward Price Arbitrage

T
1 rUS
F0 E0
1 rUK

If r(US)=0.05, r(UK)=0.06 while E0=$1.60, then F0=$1.585

What if future price is $1.57? Show how we can arbitrage.

Initial CF CF in 1 year
Borrow 1 U.K pound. Convert to USD 1.60 -E1x(1.06)
Lend $1.60 in the US -1.60 1.60x(1.05)
Long future price to buy 1.06 pounds at 0 1.06x(E1-1.57)
F0=$1.57
Total 0 $0.0158
 A generalized strategy

Initial CF CF in 1 year
Borrow 1 U.K pound. Convert to USD $E0 -E1x(1+rUK)
Lend the proceeds from borrowing in UK -$E0 E0x(1+rUS)
in the US
Long future price to buy (1+rUK) pounds at for 0 (1+rUK)x(E1-F0)
F0 dollars
Total 0 E0(1+rUS)-F0(1+rUK)
When no arbitrage profit exists, E0(1+rUS)=F0(1+rUK)
1 rUS
F0 E0
1 rUK
OR