A portfolio manager is interested in purchasing an instrument with a call option-like payoff but does not want to have to pay money up front. The manager learns from a banker that one can do this by entering into a break forward contract.
The manager wants to learn if the banker is quoting a fair price. The stock price is 437.55. The contract expires in 270 days. The volatility is 18 percent and the continuously compounded risk-free rate is 3.75 percent. The exercise price will be set at the forward price of the stock.
a. Determine the exercise price.
b. The loan implicit in the break forward contract will have a face value of 40.19. Determine if this is a fair amount by using your answer in a and computing the value of K.
c. Regardless of whether the break forward is found to be fairly priced, determine the value of the position if the stock price ends up at 465 and at 425.