Question

In: Finance

You are given: (i) The current price of a stock is $40. (ii) A one-year forward...

You are given:

(i) The current price of a stock is $40.

(ii) A one-year forward contract on the stock has a price of $42.

(iii) The stock is expected to pay a dividend of $1 six months from now and a dividend of $ 1.5 one year from now, immediately before the one-year forward contract expires.

Find the positive effective annual risk-free interest rate

Solutions

Expert Solution

The annual Risk free Interest Rate is 10.784% approximately (Continuously Compounded). Forward Price of any stock/bond is the Spot Price multiplied by exponential raised to the power of risk free interest rate(continuously compounded) times the time period (as shown below).

In this case Dividends will be paid twice. We need to find the Present Value of the dividends, subtract it from the Spot Price and then multiply the balance term with the exponential term mentioned above(also shown below).

But to find the Present value we need Risk free Rate(which we are supposed to find). Hence, I have used "Goal Seek" in excel to find the same. You can find the images below to see the working :-

jeff jeffy answered 1 year ago
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