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

A forward contract on a stock paying a continuous dividend yield is priced above the no-arbitrage level F0 = S0 e^{(r−q)T}. Which strategy locks in an arbitrage profit?

When the forward is too expensive, sell the forward, borrow to buy the stock, and deliver it at maturity. The forward price received exceeds the financed cost of holding the stock net of dividends, producing a riskless profit.

  1. ABuy the forward and short the stock, investing proceeds
  2. BSell the forward, borrow money, and buy the stockCorrect
  3. CBuy the forward and buy the stock
  4. DSell the forward and short the stock

Explanation

If the forward is overpriced, sell it and replicate the asset synthetically by borrowing to buy the stock with dividends reinvested. At maturity deliver the stock and receive the high forward price, repaying the loan for a riskless gain. The opposite position applies only when the forward is underpriced.

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