Mr. Lam holds title to an asset worth €125.72. In order to raise money for an unrelated purpose, he plans to sell the asset in nine months. But Mr. Lam is concerned about the uncertainty in the price of the asset at that time. He has learnt about the advantages of using forward contracts to manage this risk and enters into such a contract to sell the asset in nine months. Assuming the risk free interest rate is 5.625 per cent;
I. Determine the appropriate price the investor could receive in nine months by means of a forward contract.
II. Suppose the counterparty to the forward contract is willing to engage in such a contract at a forward price of € 140. Explain what type of transaction the investor could execute to take advantage of the situation. Also calculate the rate of return (annualized), and explain why the transaction is attractive.
III. Suppose the forward contract is entered into at the price you computed in Part I above. Two months later, the price of the asset becomes to €118.875. Evaluate the position of Mr Lam with respect to any gain or loss accrued on the forward contract at this point in time.
IV. Determine the value of the forward contract at expiration assuming the contract is entered into at the price you computed in Part I above and the price of the underlying asset is €123.50 at expiration. Explain how Mr Lam did on the overall position of both the asset and the forward contract in terms of rate of return.
V. Explain with examples how a forward contract can be terminated prior to expiration.