FINA2322ABC Tutorial 2
THE UNIVERSITY OF HONG KONG
HKU BUSINESS SCHOOL
FINA2322ABC – DERIVATIVES
FIRST SEMESTER, 2024-2025
Tutorial 2 – Pricing of Forward
Pricing of forward contract
✓ Arbitrage
- Arbitrage opportunities arises from mispricing
- Riskless profit can be earned from arbitraging
- The profit should be stock price invariant
- At least one of the CF at time = 0 or time = T is zero
✓ Pricing of Forward by No Arbitrage Assumption
With discrete Dividends:
CF
Transaction t=0 t=T
Buy Stock
Short ZCB
Sell forward
Total
Assuming no Arbitrage,
FINA2322ABC Tutorial 2
Understand the continuous dividend yield:
Assume you purchase 1 share of stock, at $100. What is your payoff in the future if you
receive a dividend yield of 𝛿% p.a. and keep reinvesting the dividend into the stock?
Time T=1 T=2 T=3 T=T
Number of
shares
Pricing of Forward with Continuous Dividends:
CF
Transaction t=0 t=T
Buy Stock
Short ZCB
Sell forward
Total
FINA2322ABC Tutorial 2
✓ Arbitrage from mispricing
Forward = Stock – Bond
Cash-and-Carry Arbitrage:
If the forward is overpriced: Long Stock and Short Forward (Buy low Sell high)
Reverse Cash-and-Carry:
If the forward is underpriced: Short Stock and Long Forward (Buy low Sell high)
Tutorial Exercise
Question 1
The S&R index spot price is 1100, the risk-free rate is 5% p.a., continuously compounded. The
stock pays a continuous dividend yield of 3%.
Suppose you observe a 6-month forward price of 1120. What arbitrage would you undertake?
FINA2322ABC Tutorial 2
✓ Currency Forwards
• Exchange rate at time = 0: 𝑥0 ($⁄𝑦𝑒𝑛)
• $ is the domestic currency, yen is the foreign currency
• Currency forwards are used to hedge the exchange rate risk.
• A carry trade is defined as borrowing at a lower interest rate and lending in a higher
interest rate → speculate the high-rate currency will not depreciate much.
• Covered interest arbitrage is a strategy to gain from mispricing of the forward contract
✓ Proof of currency forward price
Time 0 Time T
Position Dollar Yen Dollar Yen
Long Forward contract on yen
Borrow yen
Convert yen to dollar at spot rate at time 0
Deposit Dollar
Total CF
FINA2322ABC Tutorial 2
Tutorial Exercise
Question 2 (Currency Forward)
Suppose the spot $/¥ exchange rate is 0.008, the 1-year continuously compounded dollar-
denominated rate is 5% and the 1-year continuously compounded yen-denominated rate is 1%.
Suppose the 1-year forward exchange rate is 0.0084.
Explain precisely the transactions you could use (being careful about currency of denomination)
to make money with zero initial investment and no risk.
FINA2322ABC Tutorial 2
Summary of Forward Formulae
𝑊𝑖𝑡ℎ𝑜𝑢𝑡 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠,
𝐹0,𝑇 = 𝐹𝑉 𝑜𝑓 𝑆0
𝑊𝑖𝑡ℎ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑖𝑛 𝑑𝑖𝑠𝑐𝑟𝑒𝑡𝑒 𝑓𝑜𝑟𝑚,
𝐹0,𝑇 = 𝐹𝑉 𝑜𝑓 𝑆0 − 𝐹𝑉 𝑜𝑓 𝑎𝑙𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑖𝑚𝑒 𝑇
𝑊𝑖𝑡ℎ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑖𝑛 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠 𝑓𝑜𝑟𝑚,
𝐹0,𝑇 = 𝑆0 𝑒 (𝑟−𝛿)𝑇
Currency Forward:
Let 𝑟𝑑 to represent the interest rate of the domestic currency, 𝑟𝑓 to represent the interest rate of
the foreign currency:
Formula: Forward
Continuous Compounding 𝐹0,𝑇 = 𝑥0 𝑒 (𝑟𝑑 −𝑟𝑓 )𝑇
APR format 𝑟 𝑛𝑇
𝑥0 (1 + 𝑛𝑑 )
𝐹0,𝑇 =
𝑟𝑓 𝑛𝑇
(1 + 𝑛 )
Commodity Forward:
Discrete storage costs 𝐹0,𝑇 = 𝑆0 𝑒 𝑟𝑇 + 𝐹𝑉 𝑜𝑓 𝑎𝑙𝑙 𝑠𝑡𝑜𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡𝑠
Proportional storage costs 𝐹0,𝑇 = 𝑆0 𝑒 (𝑟+𝑢)𝑇
With convenience yield 𝐹0,𝑇 = 𝑆0 𝑒 (𝑟−𝑦)𝑇
With storage costs and convenience yield 𝐹0,𝑇 = 𝑆0 𝑒 (𝑟+𝑢−𝑦)𝑇
FINA2322ABC Tutorial 2
Value of Forward
Tutorial Exercise
Question 3
The S&R index spot price is 1100, the risk-free rate is 5% p.a., continuously compounded. The
stock pays a continuous dividend yield of 3%.
Suppose you entered a long position in 1-year forward contract. The forward contract is fairly
priced. 3 months later, the S&R index increases to 1150, while the interest rate and dividend yield
remain unchanged. What is the value of your forward position?
