Can anyone help me with this simple model.

[John Jones]

I'm having trouble with this question. (I am an undergraduate).

Given: stock is currently selling for $50 per share. A forward contract is available to buy 100 shares of the stock 3 months from now for $51 per share.

The payoff for the forward contract is given by X = Price at end of 3 months - 51

Bank is offering a 3 month CD with an interest rate of 8% compounded annually and you have 5000 in principal.

Using the CDs, Stocks, and forward contracts describe an arbitrage profit and the amount of the profit.

Any ideas as to how I can approach this? So far we have only discussed a finite binomial model for European contingent claims.

Thank you guys for any help or tips you may have.

 

[financeguy]

borrow $5000 today and buy $5000/50 = 100 shares of stock
sell those 100 shares of stock 3m forward for 100*51 = $5100
you will owe $5000*(1+8%)^(1/4) = $97.13 in interest for the $5000 you borrowed
so you have made $5100-$5000 = $100 from the spot vs forward underlying price neutral transaction and you owe $97.13 in interest, meaning you have made $100-$97.13 = $2.87 in 3m out of thin air (arbitrage)