expected spot price vs. futures price

From Schweser p.44

Most likely situation: future prices are less than expected spot price

Reason: Future price to be lower than the expected price in the future to compenstate the future buyer for accepting asset price risk.

  1. In the real world, is this usually the case?

  2. Future price can be calculated but how we know the expected spot price? Thanks.

  1. Yes

  2. You don’t. If you did you would make a killing in the stock market and never have to take an exam.

Ha, got it. Thanks!

This isn’t true. You do know the expected spot price; it’s the current spot price increased by the risk-free rate.

What you don’t know is the actual future spot price. That’s the one that would allow you to make a killing.

I disagree. FV of the current spot price using the risk-free rate is at best the opportunity cost for that money. Nobody says that is the central expectation of the spot price.

Imagine the stock in a company growing its earnings and sales in a fairly steady manner for 10-12% each year. Current stock price is $127 with a reasonable P/B ratio. It is headed by an octogenarian who has proven himself over and over, all the while media pundits say he is losing his touch. Lately because he bought a chunk of a tech company with falling sales and threat from a cloud.

What is the expected price of this stock 1 year from now, if the risk-free rate (assuming inflation of 1% and 10Y treasuries at 2.5%) is about 1.5%? Somehow, $128.905 seems inadequate.

When I put it like that, maybe I should buy more :slight_smile: But I am already at 20% of my portfolio in this one stock. There is specific risk to cconsider.

Fair enough. But the fact remains that you won’t make nearly the killing by knowing the expected value in advance as you will by knowing the actual value in advance.

^ Thinking more about this - if the strong EMH held, you may be right.

If all knowledge, private and public, is correctly reflected in the current spot price, and since future is unknowable, we treat any future developments as random, with an expected (average) impact of 0 on the price, then the best we can say is that the security will be worth today’s price * (1 + RFR.) If it wasn’t, then the security is mispriced and the efficient market will arbitrage that mispricing away in a nanosecond with no frictional costs to do so.