CFA Level I · CFA Level I Exam · Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives
An investor compares the no-arbitrage forward price of a contract on a non-dividend-paying stock with the current spot price. Holding all else constant, the forward price is most likely higher than the spot price because:
The forward price exceeds spot because holding the underlying until delivery costs foregone interest at the risk-free rate. With no dividends or other benefits to offset it, no-arbitrage pricing compounds the spot price at the risk-free rate, so the forward is higher.
- Athe risk-free rate is positive, so carrying the stock costs foregone interestCorrect
- Bthe stock has no convenience yield
- Cthe forward buyer bears the stock's price risk
Explanation
Buying the asset today requires funding, which costs the risk-free rate. With no benefits from holding the stock, the forward price is S0(1+r)^T, which exceeds spot when r is positive. The risk-bearing explanation is wrong because forward prices come from arbitrage, not from risk compensation.
Did you get it right without looking?
One question tells you little. A timed set on Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives shows your real accuracy, how long you take and where you lose marks.
More Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives questions
- When an arbitrage opportunity exists because a derivative is priced below its no-arbitrage value, the actions of arbitrageurs buying the der…
- An arbitrage opportunity is best described as a transaction that:
- A stock trades at 100. After one period it will be either 120 or 80. The risk-free rate is 5% per period. The risk-neutral probability of th…
- A stock trades at $50 and pays no dividends. The annual risk-free rate is 4% (discrete compounding). The no-arbitrage price of a 9-month for…
- A stock is at 50 and will be either 60 or 40 after one period. The risk-free rate is 5% per period. A call option with a strike of 50 is rep…
- In a one-period binomial model, an analyst prices a derivative by building a portfolio of the underlying and a risk-free bond that replicate…