LEND THE PROCEEDS OF SHORT SALE. THE PROCEEDS OF THE SHORT SALE (31...

3. Lend the proceeds of short sale. The proceeds of the short sale (316 cents/lb) can be invested (loaned) for three months at a yield of 5%. At maturity, the proceeds of loan is will be 319.97 cents/lb (316e

(.05)(3/12)

). The profit associated with the reverse cash-and-carry arbitrage is 2.19 cents/lb. Reverse cash-and-carry arbitrage Cash Flows Transaction Time 0 Time T = 3/12 Long forward 0 -313 cents/lb Short sell copper @ lease rate = 6% 316 cents/lb Pay lease rate -4.78 cents/lb Lend short-sale proceeds @ 5% -316 cents/lb 319.97 cents/lb Total 0 2.19 cents/lb PART C The no-arbitrage price range for the forward price is: S

0

e

^(r+λ-c)T

≤ F

0,T

≤ S

0

e

^(r+λ)T

. 2008 Level III Guideline Answers Morning Session – Page 22 of 40 Question: 6 Topic: Portfolio Management – Alternative Investments Minutes: 11 Where: S

0

- spot price of the asset r – the continuously compounded interest rate T – time until expiration of the forward contract F

0,T

– today’s price of forward contract that matures at T λ – storage cost c– convenience yield The convenience yield is the benefit from physical ownership. The convenience yield affects the no-arbitrage range for the forward price through the cost of short selling. An arbitrageur who wants to short spot copper would need to compensate the lender of copper for the loss of the convenience yield. Thus, a higher convenience yield will increase the cost of shorting spot copper and decrease the lower bound of the no-arbitrage range for the forward contract. The upper bound is unaffected, resulting in a wider no-arbitrage price range.Morning Session – Page 23 of 40 Question: 7 Topic: Portfolio Management – Risk Management Minutes: 17 Reading Reference: