male voiceover: let's say that thecurrent market settlement price for a futures contractthat specifies the delivery of a thousand pounds ofapples on october 20th and just for the simplicityof the math in this example, let's assume that that is one year away
aapl stock futures, and the current settlementprice, the current market price on the future exchange fordelivery on that date is $300. let's also assume thatthe current market price, if you were to buy or sellapples today not on october 20th,
which is a year awaybut today, let's assume that the current market price is $200. let's also assume that if youwere to take out a $200 loan that you would have to pay 10% interest. if you were to borrow $200 today, you would essentially haveto pay back $220 in a year. now, given all of theparameters that i've set up, is there a way to make risk-free profits? is there way to kind ofarbitrage 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 garageor some place like that and then we also sellor i guess we could say, we become the seller onthis futures contract
or we sell the futures short, i guess is another way to think about it. we also become the selleron the futures contract. essentially, we are agreeingto sell 1,000 pounds of apples on october 20th, a year from now for $300. so i wanna show you isif 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'recalling it an arbitrage
because if you fast forward one year, so let's fast forward one year. in one year, we definitelyhave 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-driedthem 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 tosettle 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 futurescontract, 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 madea guaranteed risk-free $80 of profit in one yearand we're not thinking about how much money i mighthave 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 priceis anything above the $220 then i'm going to make a risk-free profit. one way to think aboutfutures pricing is even
if you think there'sgoing to be a cold snap and apples are going to disappear and there's going to bethe 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 priceis more than the cost of borrowing the same amount of money,
the cost of borrowing $200. in this situation, thecost of borrowing is $20. the settlement price really shouldn't be, if we assume that there'sno arbitrage opportunities, it really shouldn't be more than $220.
