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Arbitraging futures contract

Created by Sal Khan.

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  • old spice man green style avatar for user Cory Hansen
    Where can I buy apples that last for a year?
    (17 votes)
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  • blobby green style avatar for user Pat Vincent
    in the last video he mentioned that carrying costs were significant in rational future prices, but there is no mention of carrying costs in this video. Why didn't he factor that in, since its just basic addition? if the carrying cost is $50, its still worthwhile to do the arbitrage scheme, still making $30 in risk free profit.
    (4 votes)
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  • leaf green style avatar for user Zaphod Beeblebrox
    But it is not that easy to borrow money from a bank right? Will a bank really lend you money to speculate in the futures market?
    (2 votes)
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  • starky ultimate style avatar for user Sudhanshu Sisodiya
    Sal says that risk and reward almost have an opposite relationship. Sal claims that he can make a risk free profit, so does that mean the reward here isn't that high?
    (2 votes)
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    • ohnoes default style avatar for user Tejas
      When you are performing arbitrage, you are only able to do so because of an imbalance in the financial system. That means that the risk-reward tradeoff is not in place any more to the extent that it should. When people do arbitrage the system, though, it will restore that balance.
      (5 votes)
  • blobby green style avatar for user Biz Bose
    How is this an example of risk-free action? There is risk that the product (apples in this hypothetical example) gets damaged, stolen etc. in the one year period between today and when the futures contract requires delivery. It seems to me that the reason the futures price would be higher than the spot price is because the market is valuing this risk at the difference between the two prices. So how is this arbitrage, which by definition is risk-free?
    (2 votes)
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    • ohnoes default style avatar for user Cameron Cotten
      You can insure the apples. You get an insurance company that has a AAA rating (defined as risk free on their financial commitments) to ensure the apples for loss or damage over the course of the year. As long as the cost of that insurance is less than $80, you still have a risk-free profit. This is part of the carrying cost that was mentioned in previous videos.
      (2 votes)
  • male robot hal style avatar for user Nicky
    Maybe it is not a quite related question, but could anyone tell me what is the differences between settlement price and delivery price? Thank you.
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      The settlement price is the price at the end of each trading day, when everyone's accounts need to be settled (ie everyone needs to have a certain minimum amount of cash in his account, and that depends on the price). The delivery price is the price at which a transaction takes place at the expiration of the contract.
      (2 votes)
  • blobby green style avatar for user David Perry
    Is this form of arbitrage possible for the average trader?
    (1 vote)
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  • aqualine seed style avatar for user K B
    What is meant by "we sell the Futures short"?
    (1 vote)
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    • blobby green style avatar for user dcpatel94
      it means one is entering a forwards contact to sell some thing at a higher price in the future whilst betting that the spot price shall remain significantly lower than the agreed delivery price in order to make a profit.
      (1 vote)
  • leafers ultimate style avatar for user Carlos Reyes
    Is this the same thing as in Real Estate?

    I get a ROI of 15% on an apartment building and the bank borrows me at 5%?
    (1 vote)
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  • male robot johnny style avatar for user shawnjain.08
    If I can sell the futures contract, then why should I even borrow money in the first place? Why not short the futures contract, getting $300, and then use the proceeds to buy $200 of apples, pocketing the difference? Is it because I need to hold some money in margin? This technique would allow me to make $100 instead of $80.
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      It costs you money to store the apples, plus you have a probability of losing money on the contract. Maybe that is worth an extra $20 to you, or maybe it's not.
      You also can't withdraw the entire $200 from your margin account.
      (1 vote)

Video transcript

Male voiceover: Let's say that the current market settlement price for a Futures Contract that specifies the delivery of a thousand pounds of apples on October 20th and just for the simplicity of the math in this example, let's assume that that is one year away and the current settlement price, the current market price on the future exchange for delivery on that date is $300. Let's also assume that the current market price, if you were to buy or sell apples today not on October 20th, which is a year away but today, let's assume that the current market price is $200. Let's also assume that if you were to take out a $200 loan that you would have to pay 10% interest. If you were to borrow $200 today, you would essentially have to pay back $220 in a year. Now, given all of the parameters that I've set up, is there a way to make risk-free profits? Is there way to kind of arbitrage this situation? And as you can imagine, there is and what we can do is, we can borrow $200, Let me list it all out. We can borrow $200 and then use that $200 to buy 1,000 pounds of apples. Then we buy 1,000 pounds of apples. We keep them in our garage or some place like that and then we also sell or I guess we could say, we become the seller on this Futures Contract or we sell the Futures short, I guess is another way to think about it. We also become the seller on the Futures Contract. Essentially, we are agreeing to sell 1,000 pounds of apples on October 20th, a year from now for $300. So I wanna show you is if we set it up this way, we are guaranteed to make money no matter what happens to the price of apples and that's why we're calling it an arbitrage because if you fast forward one year, so let's fast forward one year. In one year, we definitely have 1,000 pounds of apples and just for the sake of simplicity, let's assume that apples don't get bad that I've somehow freeze-dried them or I don't know. These are apples that never spoil. (chuckles) Let's say a year from now, I have the thousand pounds of apples so I give the apples to settle the Futures Contract. Give apples to settle the contract and then of course, I have my loan. I have my loan of $200 but guess what? When I settled the contract, when I settled the Futures Contract, I got $300. So, I get 300 dollars and what do I owe? Well, I owe $220 on my loan. Let me subtract that out. I owe $220 and so I made a guaranteed risk-free $80 of profit in one year and we're not thinking about how much money I might have had to set aside for margin but this essentially, just free money and if you think about it, if this settlement price is anything, if the settlement price is anything above the $220 then I'm going to make a risk-free profit. One way to think about Futures pricing is even if you think there's going to be a cold snap and apples are going to disappear and there's going to be the shortage of apples and so you might say, "Hey, maybe the apple prices "will go up." a year ago, there's always going to be a way to arbitrage it if the settlement price, if the growth in price is more than the cost of borrowing the same amount of money, the cost of borrowing $200. In this situation, the cost of borrowing is $20. The settlement price really shouldn't be, if we assume that there's no arbitrage opportunities, it really shouldn't be more than $220.