[ 2009 FRM Sample Exam ] Market risk measurement and management Q22 management, statements, currently, describes, following

Babul

 

22. Suppose a non?dividend?paying financial asset is currently selling for USD 1,000 and the 1?year forward price for this asset is USD 1,080. The current continuously compounded risk?free rate for 1 year is 6%. Based on the given information, which of the following statements most accurately describes the market opportunity?

A. The investor should sell the asset, lend out the proceeds and buy the forward to earn an arbitrage profit.

B. The investor should borrow funds, buy the asset and sell the forward to earn an arbitrage profit.

C. The investor should borrow funds, sell the asset and buy the forward to earn an arbitrage profit.

D. There is no arbitrage profit on this asset, and the investor is indifferent about buying or selling the asset and selling or buying the forward.

Babul

 

Correct answer is Bfficeffice" />

For no arbitrage, $1,080 = $1,000 X e(0.06 X 1). The right-hand side of $1,061.84 is not equal to the left-hand side. That means forward price today is higher ($1,080) than what it should be ($1,061.84). Therefore, the investor should borrow $1,000, buy the asset today from the borrowed funds and sell the forward for $1,080, to make a profit of $18.16 at maturity.

Reference: John Hull, Chapter 3.

Type: Market Risk.