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Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.

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# Arbitraging futures contracts II

Video transcript

Let's say that the settlement
price for delivering 1,000 pounds of
apples on October 20, which we're going to assume
is one year from now, let's assume that it's $200. Let's also assume that
the current market price for 1,000 pounds
of apples is also $200. So that future settlement
price is the same as the current market price. And we're also going to
assume, like the last example, that these apples that
we have never go bad. They're just things that
they never rot or anything. So they're as good in a
year as they are right now. Let's also assume, above
and beyond the assumptions of the last video, that
we can borrow and sell apples in the current market. That we can actually
short apples. So I go to someone who's got
1,000 pounds of apples who doesn't really see any need
for them over the next year, and I say, can I
borrow those apples? And what I do is I say,
I'll borrow those apples. I'll sell those apples
in the market today. And of the interest that
I get on those apples, I'm going to give you
1%, the person who actually owns the apples. And that person says,
oh, sure, why not? That way I actually get
some money on my apples that I had no intention
of using for a year. And then I, as the borrower
and seller, will get 4% net. I'll get 4% net on the apples. So given this reality, what
could I do, once again, to make a risk-free profit? Well, as you could imagine,
I can borrow and sell the apples for a year. So let me write this down. I'm going to borrow and
sell 1,000 pounds of apples. So if I just borrow
it today and sell it, today's market price is
$200 for 1,000 pounds. So I'm going to get $200. Now on top of that,
what I want to do is agree to be the buyer
on this futures contract. So let me write that down. Agree, you could say to go
long the futures contract, or agree to be buyer
on futures contract. So I'm agreeing,
a year from now, to buy 1,000 pounds
of apples for $200. So let's fast forward. Let's fast forward one year. So what's happened? So of the $200 I got
from shorting the apples I got 5% on that. But I had to give
1% to the person I borrowed the apples from. So I'm getting 4% net. 4% on $200 is $8. So now I now have $208 because
I got that 4% interest. It was $210. I gave $2.00 to the person
who lent me the apples. Now I can use $200 of
that to essentially uphold my part of
the futures contract, to buy the apples for $200,
for that agreed upon price. So $200 to buy apples. And I know I can do this
regardless of what the market price is because that was the
delivery price on the futures contract. So now I have $8 net. And those apples that
I've just bought, those 1,000 pounds
of apples, I can then use those apples to
return it to the person that I borrowed the apples from. So they got their apples back. And they got that 1% on the $200
over the course of the year. And I made a risk-free $8. So if you think
about it once again, this is setting a lower bound
on what the actual settlement price on the
futures contract is. I should not be able to
make this risk-free profit. If it's available,
then people will do it. And what it will do is
it will increase demand to be the buyer here. So this price should go up. And it would increase supply
on the selling side here. And so maybe this price
over here would go down.