Consider a 1year futures contract on an investment asset tha

Consider a 1-year futures contract on an investment asset that provides no income. It costs $2 per unit to store the asset, with the payment being made at the beginning of the year. Assume that the spot price is $400 per unit and the risk free rate is 10% per annum for all maturities. b) If currently the bid and ask on this 1-year futures contract are $444.5 and $445 respectively, what will you do? Please be specific and describe what this would mpy jris asset provides a lump sum income distribution mid year that you forgot to estimate in a above would you still be confident about your suggestion in b? Please explain (C is the important question, so please elaborate on this question)

Solution

Answer b)

The price of a futures contract is determined by the spot price of the underlying asset, adjusted for time plus benefits and carrying costs accrued during the time until settlement.

Generally, the price of a futures contract is related to its underlying asset by the spot-futures parity theorem, which states that the futures price must be related to the spot price by the following formula:

Futures Price = Spot Price × (1 + Risk-Free Interest Rate) + Storage cost – Incomes)

= $400 * (1 + 0.10) +$2 - $0

= $442

Therefore, the price of future contract should be $442, Where as the Quoted price of future contract are $ 445. Accordingly Futures contracts are overpriced. This would imply that one should not enter into Future Contract.

Answer c)

Even if this asset provides a lump sum income distribution mid year that I forgot to estimate in above, I would still be confident about my suggestion in b) because if I consider lumpsum income in the above formula, the price of future contract would be lower than $442. Which means Future conract are more overpriced in the market as compared to Theoretical price.