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Suppose we know the following information: The spot price of oil is USD 100; The quoted 1-year futures price of oil is USD 110; ? The 1-year USD interest rate is 5% per annum (annual compounding): The storage costs of oil are 2% per annum (paid at the end of the period)
Suppose we know the following information: The spot price of oil is USD 100; The quoted 1-year futures price of oil is USD 110; ? The 1-year USD interest rate is 5% per annum (annual compounding): The storage costs of oil are 2% per annum (paid at the end of the period). Describe the arbitrage opportunity from the above information. Draw a table to show the cash flow of your identified arbitrage strategy.
Expert Solution
Annual compounding to continous compounding = m*(ln(1 + R/m))
= 4.88%
Fair Value of the Forward contract = S0*e^((r%+cost%)*t)
= 100*e^((0.0488+.02)*1)
= $107.12
Current Quoted 1-year forward contract price = $110
So, yes arbitrage opportunity exists.
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Forward Price = 110 |
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Now: Borrow Rs. 100@ 4.88% p.a. Buy Oil on spot @ Rs. 100 Short 3 months Forward @110 Net Cash Flow 1 Year later: Deliver oil Receive payment Repay the loan with interest Storage Cost @2% p.a. Net Cash Flow |
100.00 -100.00
NIL
110.00 -105.00 -2.02 +2.98 |
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