Article – 1:
Commodity forwards and Futures. (Robert McDonalds)
Through my next 10 articles, I would like to explain and
take you to the FRM exam level questions.
Due to my busy schedule and my own preparation
for part – II (FRM), I could not write anything for the last 10-15 days. But
please follow me through this blog, I am sure, you can answer the questions in
your exam.
Before we start discussing about the article written by
Robert McDonalds on Commodities(Chapter 10), we need to understand the
following points:
The price of an asset is expected to grow at a certain rate,
say ‘r’. The asset can be a financial asset or non-financial asset.
We expect that the asset will grow at least with a rate of return to be equal to T-bills
rate of interest or Government bond rate of interest. This is also known as
risk free rate.
There are two ways to calculate the future value of an
asset. One is discrete compounding method and the second one is continuous
compounding method.
Generally in all our calculations, we use continuous
compounding rate only.
For example, if we want to deposit $1000 in bank with 5%
rate of interest for one year, we expect to receive an amount of $1051.27
The above figure is arrived by taking:
S0 (Spot investment or spot price of the
financial asset) = $1000
Rate of interest ( r ) = 5% or 0.05
Time (t) = 1 year
Using the formula: S0ert
Putting all the above values, we can obtain the value of
$1051.27 as the amount to be received after one year.
The amount $1051.27 is
known as the future value of the present financial asset.
Now, we need to understand any investor who is holding an
asset with him expects that the price of the asset grows at a certain rate.
We expect that the price will grow at least with risk free
rate. Therefore the future value of an asset is given by the formula: S0ert
Please send your valuable comments and queries to:
well written article. I would like to expand on the following point mentioned by Prof Surya about the risk free rate.
ReplyDelete//We expect that the asset will grow at least with a rate of return to be equal to T-bills rate of interest or Government bond rate of interest. This is also known as risk free rate.//
Freshers to finance generally are intrigued by the concept of risk free rate. What exactly is the risk free rate ? To answer that question we have to consider what an investor looks for while investing. He has several choices and he can choose among different investments depending on his risk appetite. The least risky being the investment where his expected return and actual return are the same ( in other words he gets a guaranteed return for his investment.) Generally Govt bonds / T-Bill rates are taken as the best investment in this category very simply because of the implicit assumption that government will not renege on its commitments.