Can someone please explain the below: the futures price is equal to the expected spot price minus a risk premium.
Think of it as a security gaurd watching over your goods for the months while you wait for delivery. You have to compensate this person for their time and the natural risk involved.
Let’s say i have a box of widgets i want to sell one month from today.
I want to protect myself in case widget prices fall in one month, so i want to gree to a price to sell widgets, today, for delivery in one month.
You and I both expect that box of widgets to sell for $100 in month.
So, today, I offer to sell it to you for $100 in one month.
You don’t care too much to buy a box of widets in one month. You especially don’t care if all you are going to do is agree to buy something for $100 that you think will be worth a $100 anyways in one month, and run the risk that’s its not actually $100 in month. There’s nothing in it for you.
So, I instead offer to sell it to you for $90. Now you are interested. You expect to make $10 in profit for taking the risk of buying the widgets from me in one month.
Here the futures price is $90, the expected spot price in one month is $100, and the risk premium is $10.
The risk premium is your compensation for taking on the risk of agreeing to buy the box of widgets today, one month forward.
I think I wrote the exact opposite of what ro424 wrote, ha!
Just the opposite side of the trade!
thanks
it seems these questions in the exam are kinda bs, there are different sides of the question, they just only focus only on the narrow side