Question YASER Finance & Economics

Derivatives: Forward Contract

A stock has an expectation to pay a dividend of $1 per share in 2 months and $1.20 in five months. The price of the stock is $80, and the risk-free rate is 8% per year with continuous compounding for all maturities. An investor has taken a short position in an 8 month forward contract on the stock. 3 months later, the price of the stock is $78 and the risk-free rate of interest is still 8% per annum. What are the forward price and the value of the short position in the forward contract?

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Answer Expert #92

-> Forward price at the start of short position

The present value of an income stream with compounding is given by: P = Ie-rT Where, r is the risk-free rate and T is time left to receive payment. The risk-free rate, r, is 8%.

Present value of $1 dividend due in 2 months = 1e-0.08(2/12) = 0.9868 Present value of $1.20 dividend due in 5 months = 1.20e-0.08(5/12) = 1.1606

Total present value of two dividends = 0.9868 + 1.1606 = 2.1474

Forward price, F0, is calculated as below: F0 = (Share price – Present value of dividends)erT

Share price is $80. The forward contract is for 8 months. Substituting values in the above equation: F0 = (80 – 2.1474)e0.08(8/12) = $82.1175

-> Three months later

Value of the short position

After three months, only one dividend of $1.2 is due in two months.

Present value of $1.2 dividend due in 2 months = 1.2e-0.08(2/12) = 1.1841

Share price at the end of three months is $78.

Five months before the expiry, present value of F0 is calculated below: Present value of F0 = 82.1175e-0.08(5/12) = $79.4253

Present value of investment to acquire a share = Current share price – Present value of dividend = 78 – 1.1841

Since the investor has a short position, value of the short forward contract, f, is given by the following calculation:

f = Present value of forward F0 – (Current share price – Present value of dividend) = 79.4253 – (78 – 1.1841) = $2.6094

Forward price at the end of three months, F1, with five months to expiry is calculated below:

F1 = (78 – 1.1841)e0.08(5/12) = $79.4196