Assignment:
Anyone can buy or sell a contract that entitles the owner (buyer) to receive $80.00 every six months for the next two years (payments made at the end of each period). When the buyer receives the final $80.00 payment, she or he will receive an addition $1,000. The cash flow is shown in the table below.
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Today
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6 months
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12 months
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18 months
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24 months
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$80.00
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$80.00
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$80.00
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$80.00 + $1,000
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The rate of return you require to invest in such a project is an 8.0 APR compounded semi-annually. It’s 8.0% since there is an alternative investment account available to you which pays an 8.0 APR compounded semi-annually. The price of the contract is $1,200.
a. In the table below, you can report future withdrawals, interests-rate payments, and ending balances for each period following a deposit made, today, into your alternative investment account. Use this table to show me how you could earn an arbitrate profit by selling the contract.
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Today
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6 months
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12 months
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18 months
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24 months
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Deposit
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Interest payment
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withdrawal amount (This is the amount required to pay the buyer of the contract)
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ending balance for period
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b. What is the no-arbitrage price of the contract described above (i.e., what is the fair value of the contract?)
c. Prove this by using the same accounting table below, that your answer to part b is indeed the fair value of the contract (i.e., you would only break even if you sold the contract).
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Today
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6 months
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12 months
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18 months
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24 months
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Deposit
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Interest payment
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withdrawal amount (This is the amount required to pay the buyer of the contract)
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ending balance for period
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