Defining The Arbitrage Arguments And Expectations

In the ideal market scenario, the relationship between the futures and the spot prices would largely depend only on the variable visible as mentioned above. However, the various market imperfections more commonly entail a different playing field, where there are elements such as transaction costs, differential borrowing and lending rates, and restrictions on short selling that eventually prevent the complete arbitrage exercise from enfolding. This then will contribute to the futures price varying within the arbitrage boundaries around the theoretical agreed price. When there is an opposite situation where the deliverable commodity in not in plentiful supply or surplus due to the fact it actually does not exists yet, the rational pricing cannot be fully applied effectively, ensuring the arbitrage mechanism cannot be applied. In such instances the price of the future is determined by the current supply and demand in place for the underlying assets in the future. The design of the relationship is such, that the “no arbitrage” setting will not affect the positioning of the stipulation within the contract, where the risk neutral probability is still maintained. This would mean a futures price would accommodate the speculator to ensure the eventual break. This scenario is achievable even when the futures market fairly prices the deliverable commodity.

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