S0 = 1000 1 yr forward price = 1100 rf = 6.75% 1) If you are long the forward, would you get paid, or would have to pay on settlement date? and what value. 2) To profit by arbitrage, can you explain the steps.
sell the forward its overpriced (agree to sell the asset at that price in the future). borrow some cash at 6.75% and buy the asset. at expiration, deliver the asset for 1100 to some chump. use the 1100 to pay back 1,067.50 you owe. You just made a clean 32.50 by sittin on your arse… 
- If you are long the forward, would you get paid, or would have to pay on settlement date? and what value. Long means buy. You’ve made a deal to buy in 1 year at 1100. 2) To profit by arbitrage, can you explain the steps. see pistol petes post
deepstack: if i rephrase the queston, what would you say indicate a payment is made by the long to the short or vice versa?
Just like they said above, but here take it in simple terms. IBM = $1000 1 yr forward price = $1100 rf = 6.75% Someone is offering to sell you IBM for $1100 in one year, or you sell him IBM for $1100. When you calculated tyhe forward price, you discovered IBM should be at $1067 in 1 year. So, would you buy it at $1100 or sell it at $1100 a year later? Naturally you will not want to buy it at $1100, so you better sell it. Enter into contract with the guy. But remember this with all arbitrage questions: You have *no* money on you at all. So, first go borrow $1000 (and pay it back as $1067 a year later). Buy IBM today at $1000. Latre sell it to the idiot and collect $1100. Pay back the loan + interest = $1067, and walk away with $32.5.
PistolPT is correct. I also have problems with ARB questions… I know the ARB is there but I always have problems showing the trade/strategy. What I find helpful is remembering that by definition, ARB needs to be RISKLESS PROFIT, ie you want to Make money WITHOUT using any of your own. So… 1. You always Buy Low, Sell High (identify the mispricing and go off of that) 2. Start off every Arb trade by borrowing money since you don’t want to use your own. 3. Choose the investment that will yield a return greater than your borrowing cost 4. On settlement, exchange is made and your proceeds will pay off your loan. The net difference is your profit.
Dreary, I follow your arb calculation, but go to book 6 and chapter 60, try to solve problem no 1b. Book is saying that short would be paying, which I am not sure how it can be.
pepp Wrote: ------------------------------------------------------- > deepstack: if i rephrase the queston, what would > you say > > indicate a payment is made by the long to the > short or vice versa? Not sure if I get your question, but payment is made by whoever is on the wrong side of the trade. If you see “payment to long” in any of your formulas, it’s only because the assumption is that the Long “wins” and his rate is lower than the Short’s rate. So if for example, say on notional $1000, Long pays FIXED rate of 5% and Short Pays FLOAT, but at settlement FLOAT= 8% Payment to Long = Notional x (Float - Fixed) Payment to Long = 1000 (8% - 5%) = 1000 x 3% = $30 Long receives $30 because he is on the right side of three. But note that technically Long and Short are BOTH paying, it’s just in terms of payment you only need to look at the NET. Whichever party the NET favors in, is the party that receives a payment.
I don’t have the book, but you are short the contract, so you will not be paying, you won. Back to IBM, the idiot is the long, you are the short. He pays you the $32.5.
Books says the short pays the long. bump!
If the idiot manages a trust, is he in violation of Prudent Investor rules ?
Dreary is right, watch the forward video again, you agreed to exchange something, so you have to. your price is locked in.