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Upper bound on forward settlement price

Upper Bound on Forward Settlement Price. Created by Sal Khan.

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  • leaf green style avatar for user Oli5679
    Doesn't he fail to take into account the oppurtinity cost of having your money tied up in gold for one year. The investor forgoes $50 risk free profit they could make from buying bonds when they follow your scheme, meaning they don't make an economic profit?
    (3 votes)
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    • leaf green style avatar for user PetoG
      You were talking about "having your money tied up in gold for one year". But you actually have no money. You just borrow some, then pay back what you are due, and you end up with a profit. Start with zero, finish with fifty. Infinite profit percentage-wise.
      (26 votes)
  • aqualine seed style avatar for user K B
    Why 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?
    (6 votes)
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  • starky ultimate style avatar for user Sudhanshu Sisodiya
    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)
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  • leaf green style avatar for user Niks Jansons
    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)
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    • ohnoes default style avatar for user Tejas
      $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)
  • leafers ultimate style avatar for user Ori
    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)
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    • ohnoes default style avatar for user Tejas
      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)
  • blobby green style avatar for user edwinfund
    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)
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    • ohnoes default style avatar for user Cameron Cotten
      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)
  • blobby green style avatar for user Darcy James
    What does upward bound/lower bound mean? I was a little confused.
    (1 vote)
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    • ohnoes default style avatar for user Cameron Cotten
      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)
  • piceratops ultimate style avatar for user Anshika Gupta
    can you please summarize the video?
    (1 vote)
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  • blobby green style avatar for user Greg Cook
    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)
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  • blobby green style avatar for user Gabriel Rohde
    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)
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Video 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.