Comparison of Short Plain Vanilla Forward Contract with Short Target Forward Contract
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Question
Assume that the one-month rate of interest is zero. What does the decomposition of the target forward in Part 2 tell you about the value of the call option embedded in the target forward? Use the following steps:
- From the information given in the question, the plain vanilla forward with delivery price 100 and the target forward with delivery price 103 each have a value of zero.
- Moreover, from Part 2, the value of the target forward is equal to the sum of the values of the short forward with a delivery of 103 and the short call with a strike of 103.
- If the forward with a delivery price of 100 is worth zero, how much is the forward with a delivery price of 103 worth? That is, how much better or worse off are you from holding a forward contract that allows you to sell at 103 when the breakeven delivery price is 100?
- Combining 1-3, how much is the short call with strike 103 worth?
Summary: This question belongs to finance and discusses about discusses about simplified version of the target forwards contracts.
Answer is in Excel format
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