Upper bound on forward settlement price | Finance & Capital Markets | Khan Academy | Summary and Q&A

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March 30, 2011
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Khan Academy
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Upper bound on forward settlement price | Finance & Capital Markets | Khan Academy

TL;DR

You can theoretically make a risk-free profit in futures contracts by buying gold at the spot price, entering into a forward contract to sell it at a higher future price, and considering interest and carrying costs.

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Key Insights

  • 🥶 Risk-free profit opportunities are rare in the real world.
  • 🇨🇷 Rational pricing in futures contracts considers spot price, borrowing cost, and carrying cost.
  • 🖐️ Arbitrageurs play a crucial role in maintaining market efficiency.

Questions & Answers

Q: How can you make a risk-free profit in futures contracts?

By borrowing money to buy gold at the spot price and simultaneously entering into a forward contract to sell it at a higher future price, you can lock in a risk-free profit.

Q: What are the costs involved in making a risk-free profit in futures contracts?

The costs include paying interest on the borrowed money and carrying costs for storing and insuring the gold throughout the year.

Q: Why is the spot price plus borrowing cost and carrying cost considered the rational price for the futures contract?

The rational price ensures that there is no risk-free profit opportunity, as arbitragers would take advantage of it. Therefore, the futures contract price should not be higher than the spot price plus borrowing cost and carrying cost.

Q: Why doesn't risk-free profit opportunities exist in the real world?

If risk-free profit opportunities existed, market forces would quickly drive prices up (in the spot market) and down (in the futures market), eliminating the opportunity for risk-free profit.

Summary & Key Takeaways

  • The spot price for gold is $1,000 per ounce, and the one-year forward settlement price is $1,200 per ounce.

  • Interest rate to borrow money is 10%, and carrying cost for gold is $50 per ounce per year.

  • By entering into a forward contract to sell gold in the future, you can make a risk-free profit of $50 by considering costs and revenue.

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