Financial engineers claim to have created a new equity derivative contract called the Basket Forward Contract. It consists of two or more equity securities in a basket. The Forward price in the contract is the theoretical forward value of the basket at the start of the contract similar to other forward contracts. The initial value of the Basket Forward Contract is zero as well. Consider the following Basket Forward Contract with Citibank and JP Morgan:
Citibank: Weight=0.30, Contract Forward Price = $50.00, Weighted Forward Price= 0.30 x $50.00 = $15.00
JP Morgan: Weight=0.70, Contract Forward Price=$75.00, Weighted Forward Price= 0.70 x $75.00 = $52.50
Basket Value = $15.00 + $52.50 = $67.50
If a trader decides to buy a 6 Month Basket Forward Contract, then the Basket Value will use the theoretical forward prices of the equities 6 Months from the start of the contract, utilizing the same proportions of 30% and 70% and totaling the resulting values.
Given this background information, traders at Lehman Brothers decided to buy 10,000 shares of the Basket Forward Contract for a period of 6 months.
a) If the current spot price of JP Morgan is $99.92 and the risk-free interest rate is quoted as 5% pa, what is the forward equity price of JP Morgan in 6 months? If the current spot price of Citibank is $61.22 and its dividend yield has been forecasted as 3% pa, what is the forward equity price of Citibank in 6 months? What is the theoretical forward basket value of the forward contract?
b) Due to financial stress in the market place, all banking stocks took a hit in 6 months. Citibank's spot price fell to $35 whereas JP Morgan's spot price fell to $85. What is the profit/loss of the contract that Lehman Brothers bought using the forward price computed in question a?
c) Are the financial engineers smart? Did they create a new contract? Why or why not?