D Question 8 2 pts Assume that you have agreed a forward contract to buy at the

Question

D Question 8 2 pts Assume that you have agreed a forward contract to buy at the fair forward price in t years on a non-dividend paying stock with spot price S, risk-free interest rates r. Assume there is no cost to borrow the stock. 1. Describe the positions that you would enter to lock in this forward price. 2. What happens if between now and the maturity of the forward contract the company decides to pay a dividend? Do you make money, lose money or are you indifferent to this change? If you make or lose money, determine the present value of this amount. HTML Editorg

Explanation / Answer

Long: You will buy on agreed future date

Short: You will sell (deliver) on agreed future date

Forward price = Spot Price * exp (interest rate* time)

2.

When dividend is paid then what happens is that the share price decreases and since we have gone Long then we will lose the money.

              We have to find the present value of the dividend by discounting it with risk-free rate and then   reduce the spot price

Present Value of dividend = Dividend / exp ( Rate* Time till dividend payment)

               New formula will be,

Future price = (Spot Price – present value of dividend)* exp (interest rate* time)

               Due to dividend we will lose by: present value of dividend* exp (interest rate* time)

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