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

A stock priced at USD 80 pays no dividends. The continuously compounded risk-free rate is 5%. A 1-year forward contract on the stock is quoted at USD 86.00, whereas the theoretical forward price is USD 84.09 (80 × e^0.05). Which arbitrage strategy locks in a riskless profit?

Borrow money, buy the stock and sell the forward. Because the forward price of 86.00 exceeds the fair value of 84.09, delivering the stock under the forward and repaying the loan of 84.09 yields a riskless profit of about 1.91.

  1. ABuy the stock with borrowed money and sell the forwardCorrect
  2. BShort the stock, invest proceeds at the risk-free rate and buy the forward
  3. CBuy the forward and sell the stock forward at the same price
  4. DSell the stock and invest in a stock index future

Explanation

The forward is overpriced (86.00 > 84.09). The arbitrageur borrows 80 to buy the stock, sells the forward at 86.00, and at maturity delivers the stock, receiving 86.00 and repaying 84.09, a profit of about 1.91. The short-and-buy-forward strategy applies when the forward is underpriced and would lose money here.

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