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Homework 4

FNCE 745

1. Let the spot price of oil on Jan 1st 2010 be \$100 per barrel. Suppose the 6-month forward price is \$98. Assume that the storage cost of a barrel of oil is 2% at an annual rate compounded continuously (paid upfront). What is the proﬁt/loss earned on a cash-and-carry transaction entered on Jan 1st 2010 and closed at the end of June 2010. The annualized interest rate is 5%. Assume that there is no lease market for oil.

Answer: We can calculate the proﬁt in two ways: Firstly, it can be written as

Proﬁt = F 0 S 0 e (r+u)·T = 98 100 e .07·0.5 = 5.5619.

Another way to calculate it is to ﬁrst calculate the lease rate. We have

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δ = r T ln(F/S) = 0.05 1/(0.5)ln(98/100) = 0.0904.

Then, we can calculate

Proﬁt = S 0 e r T e .0904·0.5 e 0.02·0.5 = 5.5619.

2. Question 6.5.

(a)

The spot price of gold is \$300.00 per ounce. With a continuously com- pounded annual risk-free rate of 5%, and at a one-year forward price of 310.686, we can calculate the lease rate according to the formula:

δ l = r

1

T

ln F 0,T

S

0

= 0.05 ln 310.686 = 0.015

300

(b)

Suppose gold cannot be loaned. Then our cash and carry “arbitrage” is:

 Transaction Time 0 Time T = 1 Short forward Buy gold Borrow @ 0.05 Total 0 310.686 − S T S T −\$300 \$300 −\$315.38 0 −4.6953

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The forward price bears an implicit lease rate. Therefore, if we try to engage in a cash and carry arbitrage, but if we do not have access to the gold loan market, and thus to the additional revenue on our long gold position, it is not possible for us to replicate the forward price. We incur a ﬁnancial loss. The ﬁnancial loss however, usually offset by the conveience of holding the commodity. It is useful to note that in the class notes, we did a similar problem for oil, where there is a positive storage cost. Here, we assume that the storage cost of gold is zero. Using the formula in the notes, we would have proﬁt = F 0 S 0 e (r+u)·T = 310.686 300e .05 = 4.6953, as in the above table.

(c) If gold can be loaned, we engage in the following cash and carry arbi- trage:

 Transaction Time 0 Time T = 1 Short forward Buy tailed gold position, lend @ 0.015 Borrow @ 0.05 Total 0 310.686 − S T S T −\$295.5336 \$295.5336 −\$310.686 0 0

Therefore, we now just break even: Since the forward was fairly priced, taking the implicit lease rate into account, this result should not sur- prise us. Some notes on the line “buy tailed gold.” It just means to buy less units today to take into account the income from leasing. In the notes we broke this up into two terms: the ﬁrst was the cash needed for purchasing the commodity, and the second was the income received from leasing. Adding up gives the cash required for the tailed position.

3. Question 6.6.

(a) The forward prices reﬂect a market for widgets in which seasonality is important. Let us look at two examples, one with constant demand and seasonal supply, and another one with constant supply and seasonal demand. One possible explanation might be that widgets are extremely difﬁcult to produce and that they need one key ingredient that is only available

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during July/August. However, the demand for the widget is constant throughout the year. In order to be able to sell the widgets throughout the year, widgets must be stored after production in August. The for- ward curve reﬂects the ever increasing storage costs of widgets until the next production cycle arrives. Once produced, widget prices fall again to the spot price. Another story that is consistent with the observed prices of widgets is that widgets are in particularly high demand during the summer months. The storage of widgets may be costly, which means that wid- get producers are reluctant to build up inventory long before the sum- mer. Storage occurs slowly over the winter months and inventories build up sharply just before the highest demand during the summer months. The forward prices reﬂect those storage cycle costs.

(b) IMPORTANT TERMINOLOGY: This question asks for the “rate of return” on a cash-and-carry. This is actually cannot be calculated, since the up front investment in such a strategy is 0. Instead, we can calculate the rate of return on a carry stategy, where the purchase of the commodity is done by the resources of the arbitrager. Let us take the December 2004 forward price as a proxy for the spot price in December 2004. We can then calculate with our carry arbi- trage tableau:

 Transaction Time 0 Time T = 3/12 Short March forward Buy December −3.00 0 3.075 − S T S T Forward (= Buy spot) Pay storage cost Total −0.03 −3.00 3.045

We can calculate the annualized rate of return as:

3.045

3.00

= e α×T

ln 3.045

3.00

= α × 3/12

α = 0.05955

which is close to the prevailing risk-free interest rate of 0.06. Had the

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forward price been given as 3.07534 = 3 exp(.06 · 3/12) + .03, the return would have been exactly the riskless rate.

(c) Let us again take the December 2004 forward price as a proxy for the spot price in December 2004. We can then calculate with our carry arbitrage tableau:

 Transaction Time 0 Time T= 9/12 Short Sep forward Buy spot Pay storage cost Sep FV(Storage Jun) FV(Storage Mar) Total 0 2.75 − S T S T −3.00 −0.03 −0.0305 −0.0309 −3.00 2.6586

We can calculate the annualized rate of return as:

2.6586

3.00

= e (α)×T ln 2.6586

3.00

α = 0.16108

= α × 9/12

This result may seem surprising. We would earn a negative annualized return of 16% on such a cash and carry arbitrage. This is because there is a positive convenience yield attached to widgets for this time span, and the loss reﬂects the beneﬁt of holding the commodity. If the commodity could be leased, then as shown in class, there would no proﬁt or loss.

4. Question 6.7

(a) Let’s back out the lease rate from the forward price. We have to adjust the formula for forwards in the class notes just a bit to take into ac- count the discrete form of the storage costs. Now we have the forward pricing formula:

F 0 = S 0 · e (ry)t + Future Value of Storage Costs

. Note the difference from the equation in the class notes: F 0 = S 0 · e (rδ)t , where δ = y u. Here, the storage cost is written separately, so, only the convenience yield is subtracted from the riskless rate in the exponentiated term.

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Back to our problem: For the 3-month forward contract we then have

3.075 = 3 · e (0.06y)0.25 + 0.03.

Therefore y = 0.06 4 ln(3.045/3) = 0.00045, which is very close to zero. The holder of the commodity does not beneﬁt very much from holding it, so will play close to zero. Instead, the borrower of the commodity will ask for the 0.03 of compensation for the storage cost. So, overall, the borrower of the commodity receives some funds for holding the commodity.

(b) Using the same formula as above, now we solve:

2.75 = 3 · e (0.06y)0.75 + 0.03(e .06·0.5 + e .06·0.25 + 1).

Note, that we need the future value of the storage costs, which are all payable at the end of each quarter. So the future value of the ﬁrst cost is compounded with two quarters of interest, the second cost for one quarter, and the last cost is paid at the third quarter so no need to ad- justment for future value. Solving the equation, we get y = 0.221068. So, the payment from the borrower to the lender should be conve- nience - costs of storage = 3 · (e .221068·0.75 1) 0.091367 = 0.44964.