This workout asks us to calculate the fair forward price of this particular forward contract, and using that to determine if an arbitrage opportunity exists. Having done so, we want to calculate the profit from the arbitrage trade and to reconcile the trades necessary from the arbitrage trade to the arbitrage profit we think we can make. So the fair forward price, take the cash price of $45, deduct from this the 50 cents dividends per share that are expected to be paid over the next one year up until the delivery date of the forward contract, but then add on to this the interest cost, the cost of borrowing money to buy the underlying stock today, that would be the 2% multiplied by the cash price of the underlying assets, giving us a fair forward price of $45.40. This is what we think the forward price should be but we're told the quoted forward price is $46. So the potential arbitrage profit is the difference between the quoted forward price and what we think the forward price should be, the fair forward price, giving us 60 cents per share. Next requirement, was to identify the trade required for this trade. For any arbitrage trade, it is necessary to buy low and sell high, so it's necessary to consider whether that quoted forward price of $46 is too high or too low. Well, it's higher than the fair forward price, so it's too high, and therefore, we need to sell the forward contract. So we're gonna sell the forward market, and to balance this out, to end up in a neutral risk position, we need to go long or to buy in the cash market.

The stages of this transaction are as follows, we need to buy the underlying asset today, having bought it we then own it, and then when the delivery date on the forward contract is arrived at in one year's time, we will deliver the underlying asset that had previously been bought and the forward price will be received, of $46, that is a cash inflow. Having bought the underlying asset and held it through the forward period, we would then also receive the dividend of 50 cents per share.

Having borrowed the $45 to be able to buy the stock for $45 at the inception of this arbitrage trade, we would then need to repay that money, so a cash outflow of $45, and we would also need to pay the interest on those borrowed funds, which was 2% of the borrowed amount, that is also gonna be a cash outflow, so 90 cents of interest would need to be paid. Taking all of those cash flows together, there is a net position of 60 cents, which matches the potential arbitrage profit previously calculated.