Calculate the theoretical fair price for forward contract

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Reference no: EM132054513

You observe that the current spot price of gold is TL400 per ounce. You also observe that the yield curve is flat and all maturities up to one year have an interest rate of 12 percent. Since gold is a popular underlying asset in the derivatives markets, you are interested in identifying any mispricing that may allow you to earn arbitrage profits. When you look up gold forward contract prices, you see that there is a contract with a one year maturity whose current price is TL410 per ounce. The size of this forward contract is 100 ounces of gold per contract. Assume that there are no transaction costs in the spot or forward markets.

a. Calculate the theoretical fair price for the forward contract.

b. Based on the price you calculated in part (a) and the price you observe in the market, comment on whether it is possible to earn an arbitrage profit. If your answer is yes, then specifically describe the transactions at time 0 and T and calculate the arbitrage profit.

Reference no: EM132054513

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