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CFA Level I · CFA Level I Exam · Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives

Compared with a non-dividend-paying stock, a forward contract on an equity index with a high dividend yield will most likely have a forward price that is:

The forward price is lower relative to spot because the owner of the index collects dividends that the forward holder does not. These benefits offset financing costs, so the no-arbitrage forward is reduced by the future value of the dividends.

  1. Alower relative to spot, because dividends are a benefit of holding the underlyingCorrect
  2. Bhigher relative to spot, because dividends raise financing costs
  3. Cequal to spot, because index forwards are cash-settled

Explanation

Holders of the index receive dividends that a forward buyer does not, so the forward price is reduced by their future value. The forward is S0 x (1+r)^T minus FV of dividends. Cash settlement does not remove this adjustment.

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