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Course: Finance and capital markets > Unit 9
Lesson 2: Forward and futures contracts- Forward contract introduction
- Futures introduction
- Motivation for the futures exchange
- Futures margin mechanics
- Verifying hedge with futures margin mechanics
- Futures and forward curves
- Contango from trader perspective
- Severe contango generally bearish
- Backwardation bullish or bearish
- Futures curves II
- Contango
- Backwardation
- Contango and backwardation review
- Upper bound on forward settlement price
- Lower bound on forward settlement price
- Arbitraging futures contract
- Arbitraging futures contracts II
- Futures fair value in the pre-market
- Interpreting futures fair value in the premarket
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Upper bound on forward settlement price
Upper Bound on Forward Settlement Price. Created by Sal Khan.
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1:10Why Sal mention risk-free bond interest? What's its significance? Does it mean that person would make 5% profit which person eventually makes in this example?(7 votes)
He just means that 5% is the yield that a person would get per annum if invested in the Safest asset (i.e.: Treasury Bonds) if you would have money to lend.(6 votes)
All of these futures & commodities trading.. Is it right to characterize all this as a form of speculation? What's the exact difference b/w speculation and investment. moreover, what would be the slight variations b/w speculation and futures trading?(3 votes)
Yes, it's all speculation.
Speculation is when you buy something with the intent to sell it later for a profit
Investment is when buy something with the intent to hold it and benefit from its cash flows.(5 votes)
Great video.
What would happen if you have the 1000 $ and you doun't have to borrow the Money? You then are making a profit, right? That meens everybody wound do that, who have 1000 $. So the futures settlement price should be 1050$.(2 votes)
$1150 is just the upper bound on the forward price. If you actually have the money, then you would not need to borrow the money, but you would still need to pay the opportunity cost of having your money tied up in the gold rather than lending it out at 5%.(4 votes)
This sounds a bit like shorting - you borrow up front to enter into the market, and then settle at a future date. What are the differences between shorting and entering into this kind of transaction?(1 vote)- This is not shorting. You are not simply borrowing gold and the selling it at a future date. You are borrowing money, and then using that to buy gold and making a contract in which you sell the gold at a higher price later on. In this, you are performing arbitrage, which results in a risk-free profit. When shorting, you are taking on huge amounts of risk.(3 votes)
I been trying to prove why this can't be done..
If gold is tradin at 1590 /oz can someone explain why what sal did In this video can't work ?
Also, in terms of "agreeing to sell in the future " how do u choose to be the "seller" int the futures contract ?
Thanks(1 vote)- He isn't saying that this can't be done.
He is saying that if you found someone who wants to pay for gold a year from now for $1590/oz, when you can get gold for $1000/oz and store it for $50/year/oz, then you had better buy as much gold as you can right away and write a contract to sell it to them a year from now at their price. You will make a profit of $440 for every ounce that you can sell this way.
He is also saying that you will probably never find this person because anyone can do this analysis and figure out that he should only pay $1150/oz for delivery of gold a year from now.(2 votes)
- What does upward bound/lower bound mean? I was a little confused.(1 vote)
- This is a good question, since he doesn't ever use the word "Upper Bound" in the video. Sal's argument is that there is a practical upper bound on forward settlement price, because it would be easy for anyone to profit by buying gold on the market today and enter into a futures contract for a year from now. Here he shows that the current 1 year contract price for gold that you can get on the market for $1200 is wrong because it is too high. He instead shows that the upper bound of that contract, ie the most someone would pay you for gold a year from now, is $1150, since if it were any higher, than there is instant profit to be made.(2 votes)
can you please summarize the video?(1 vote)- If you did not have to borrow the money at 10% in this example, could you make 10% if you paid cash for the spot price of gold and sold the 1-year contract?(1 vote)
- If I've already had the money, I can make 10% profit risk-free. This is higher than the 5% risk-free bound, so there is an arbitrage opportunity. The Future Gold price must be $1050. Am I wrong?(1 vote)
- Although Sal used a forward contract to illustrate, in practice a futures contract also involves margin trading and margin maintenance costs. So, even if these numbers were realized in the real world, it's not quite risk-free money.(1 vote)
1:10Video transcript
Let's see if there's a way
to make a risk free profit. And let me just tell you
right from the get go, there's usually not
many ways to make a risk free profit in the world. So this is very theoretical. If the spot price for
gold was $1,000-- so the spot price literally
just means the market price. If you were to buy or sell gold
today and actually exchange hands, then you
would pay or sell the gold for $1,000 per ounce. And let's also say that the
one year forward settlement price is $1,200 per ounce. So if you want to buy
gold one year from now, you could agree right
now to buy it for $1,200. Or if you want to sell
gold one year from now, you could agree right
now to sell it for $1,200 by entering into a forward,
or futures, contract. And just the other details, the
interest rate to borrow money is 10%, and the carrying cost of
gold is $50 per ounce per year. And the carrying cost means,
if I had an ounce of gold, and I wanted to hold
it responsibly-- I wanted to store it, maybe
someplace in a safe at a bank, and I wanted to insure
it in case it got stolen, or in case someone lost
it-- that would cost me $50 per ounce per year. So that's what we
mean by carrying cost. Let's say you could
also invest money risk free in this type of a
market-- I've just made up these numbers-- for 5% a year. So, how could you
make the money? We're assuming you
start with nothing. So you could literally
just borrow $1,000, and then you use that
to buy an ounce of gold in the spot market, and you also
agree to sell it in the future. So you enter into
that forward contract. Let me write this way-- enter
into forward as the seller. So, on the spot market
you are the buyer, and on the forward
market, one year from now, you agree to be the seller. So, let's just think about
how this is going to play out. So over the course of the
year, you will have some costs. You will have to pay the
interest on this $1,000. That's 10%. So you're going to
pay $100 in interest. And you're going to pay the
carrying cost, $50 per ounce. So $50 carrying cost. And so, when we end
up a year from now, you will sell the gold $1,200. And you know you can
do that, because you entered into the
forward agreement. And then you can pay back the
$1,000 loan plus $100 interest. And let's say you have
to pay the carrying cost at the end of
the year to the bank. So plus the $50 carrying cost. So how much did we profit? Well, we get $1,200, and
we have to pay back $1,150. So $1,200 minus $1,000
minus $100 minus $50, we make a profit of $50. So the big takeaway here is
that these type of things normally don't exist. If they did, people would
do it all day and all night. And this price would
go up, because everyone would want to buy on
spot, and this price would go down because
everyone would want to sell in
the futures market. Everyone would want
to do this right here. So the appropriate price
is, this price, based on these numbers
right here should not be any higher than $1,150. So, the correct
market price here, if we didn't want
to risk free profit or essentially what the
arbitragers would make happen by taking
advantage of this, it would eventually
go to $1,150. So it's essentially
the spot price plus the cost to borrow
money at that spot price plus the carrying cost. So that's essentially
what would be the rational price for
the futures contract, or the forward settlement price.