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FRM Part I · FRM Exam Part I · Pricing Financial Forwards and Futures

A commodity has spot 60, r = 5% continuous, and storage costs of 2% per year continuous. The market 1-year forward price is 66.0. The no-convenience-yield model price is 60e^0.07 = 64.35. A trader wants to exploit the difference. Which action is the arbitrage, and approximately what is the riskless profit at year-end?

Because the forward at 66.0 exceeds the cost-of-carry value of 64.35, execute cash-and-carry: borrow to buy the commodity, pay storage, and sell forward. The riskless profit at year-end is 66.00 minus 64.35, about 1.65.

  1. ABorrow 60, buy the commodity, pay storage, sell forward at 66.0; profit about 1.65Correct
  2. BShort the commodity, invest proceeds, buy forward at 66.0; profit about 1.65
  3. CBorrow 60, buy the commodity, sell forward; profit about 6.00
  4. DBuy forward at 66.0 and short the commodity; profit about 3.65

Explanation

The forward is above the cost-of-carry price 64.35, so it is overpriced: buy spot (financed by borrowing, incurring storage) and sell forward. Profit = 66.00 - 64.35 = 1.65. Shorting the commodity is for an underpriced forward. 6.00 ignores financing and storage costs.

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