Hull-OFOD8e-Homework_Answers_Chapter_05-ver_01.

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CHAPTER 5
Answers to Homework Exercises
Problem 5.3.
Suppose that you enter into a six-month forward contract on a non-dividend-paying stock when the stock price is $30
and the risk-free interest rate (with continuous compounding) is 12% per annum. What is the forward price?
The forward price is
0 12 0 5
30 $31 86 e
. .
= .

Problem 5.9
A one-year long forward contract on a non-dividend-paying stock is entered into when the stock price is $40 and the
risk-free rate of interest is 10% per annum with continuous compounding.
a) What are the forward price and the initial value of the forward contract?
b) Six months later, the price of the stock is $45 and the risk-free interest rate is still 10%. What are the forward
price and the value of the forward contract?
Answer:
a) The forward price,
0
F , is given by equation (5.1) as:

0 1 1
0
40 44 21 F e
.
= = .
or $44.21. The initial value of the forward contract is zero.

b) The delivery price K in the contract is $44.21. The value of the contract, f , after six months is given
by equation (5.5) as:

0 1 0 5
45 44 21 f e
. .
= . 2 95 = .
i.e., it is $2.95. The forward price is:

0 1 0 5
45 47 31 e
. .
= .
or $47.31.

Problem 5.10.
The risk-free rate of interest is 7% per annum with continuous compounding, and the dividend yield on a stock index is
3.2% per annum. The current value of the index is 150. What is the six-month futures price?
Using equation (5.3) the six month futures price is

Problem 5.15.
The spot price of silver is $15 per ounce. The storage costs are $0.24 per ounce per year payable quarterly in advance.
Assuming that interest rates are 10% per annum for all maturities, calculate the futures price of silver for delivery in
nine months.
The present value of the storage costs for nine months are

. The futures
price is from equation (5.11) given by
0
F where
0 1 0 75
0
(15 000 0 176) 16 36 F e
. .
= . + . = .

i.e., it is $16.36 per ounce.
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Further Questions
Problem 5.25
The current USD/euro exchange rate is 1.4000 dollar per euro. The six month forward exchange rate is 1.3950. The six
month USD interest rate is 1% per annum continuously compounded. Estimate the six month euro interest rate.
If the six-month euro interest rate is rf then
5 . 0 ) 01 . 0 (
4000 . 1 3950 . 1

=
f
r
e

so that
00716 . 0
4000 . 1
3950 . 1
ln 2 01 . 0 = |
.
|

\
|
=
f
r
and rf = 0.01716. The six-month euro interest rate is 1.716%.
Problem 5.26
The spot price of oil is $80 per barrel and the cost of storing a barrel of oil for one year is $3, payable at the end of the
year. The risk-free interest rate is 5% per annum, continuously compounded. What is an upper bound for the one-year
futures price of oil?
The present value of the storage costs per barrel is 3e
-0.051
= 2.854 ($/bbl). An upper bound to the one-year futures
price is (80+2.854)e
0.051
= 87.10 ($/bbl).
Problem 5.27.
A stock is expected to pay a dividend of $1 per share in two months and in five months. The stock price is $50, and the
risk-free rate of interest is 8% per annum with continuous compounding for all maturities. An investor has just taken a
short position in a six-month forward contract on the stock.
a) What are the forward price and the initial value of the forward contract?
b) Three months later, the price of the stock is $48 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?
Answer:
a) The present value, I , of the income from the security is given by:

0 08 2 12 0 08 5 12
1 1 1 9540 I e e
. / . /
= + = .
From equation (5.2) the forward price,
0
F , is given by:

0 08 0 5
0
(50 1 9540) 50 01 F e
. .
= . = .
or $50.01. The initial value of the forward contract is (by design) zero. The fact that the forward
price is very close to the spot price should come as no surprise. When the compounding frequency
is ignored the dividend yield on the stock equals the risk-free rate of interest.

b) In three months:

0 08 2 12
0 9868 I e
. /
= = .
The delivery price, K , is 50.01. From equation (5.6) the value of the short forward contract, f , is
given by

0 08 3 12
(48 0 9868 50 01 ) 2 01 f e
. /
= . . = .
and the forward price is

0 08 3 12
(48 0 9868) 47 96 e
. /
. = .


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Problem 5.28.
A bank offers a corporate client a choice between borrowing cash at 11% per annum and borrowing gold at 2% per
annum. The risk-free interest rate is 9.25% per annum, and storage costs are 0.5% per annum. Discuss whether the
rate of interest on the gold loan is too high or too low in relation to the rate of interest on the cash loan. Assume that:
- if gold is borrowed, interest must be repaid in gold. Thus, 100 ounces borrowed today would require 102
ounces to be repaid in one year.
- The interest rates on the two loans are expressed with annual compounding.
- The risk-free interest rate and storage costs are also expressed with continuous compounding.

ANSWER. Suppose that the price of gold is $1000 per ounce and the corporate client wants to borrow $1,000,000.
The client has a choice between borrowing $1,000,000 in the usual way and borrowing 1,000 ounces of gold. If it
borrows $1,000,000 in the usual way, an amount equal to 1, 000 000 1 11 $1,110, 000 , . = must be repaid. If it
borrows 1,000 ounces of gold it must repay 1,020 ounces. In equation (5.12), r=0.0925 and u=0.005 so that the
forward price is

By buying 1,020 ounces of gold in the forward market the corporate client can ensure that the repayment of the
gold loan costs

Clearly the cash loan is the better deal ( ).
This argument shows that the rate of interest on the gold loan is too high. What is the correct rate of interest?
Suppose that R is the rate of interest on the gold loan. The client must repay ounces of gold. When
forward contracts are used the cost of this is

This equals the $1,110,000 required on the cash loan when 0 688 R % = . . The rate of interest on the gold loan is too
high by about 1.31%. However, this might be simply a reflection of the higher administrative costs incurred with a
gold loan.
NOTE that this is not just an artificial question. Many banks are prepared to make gold loans.