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I am currently studying the convergence of futures price to spot prices.

I know that as the delivery month of a futures contract is approached, the futures price converges to the spot price of the underlying asset. When the delivery period is reached, the futures price equals—or is very close to—the spot price.

However why text book gives an example to explain this:

To see why this is so, we first suppose that the futures price is above the spot price during the delivery period. Traders then have a clear arbitrage opportunity:

1.Short a futures contract.

2.Buy the asset.

3.Make the delivery.

'These steps are certain to lead to a profit equal to the amount by which the futures price exceeds the spot price. As traders exploit this arbitrage opportunity, the futures price will fall.'

Why would he sell the future's contract? Does this have to do with futures prices being higher than short prices?

I don't get the 'short a future contract'. I know it means selling a future contract, but then it states to buy the asset . Which asset? What does selling a future contact have to do with buying an asset?

If you sell a futures contract, what asset would you be buying?

Why are these steps certain to lead to a profit equal to the amount by which the futures price exceeds the spot price?

I am new to finance so a simple explanation of what im not understanding would be great! Thanks!

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When you sell the futures contract, the contract basically says that, if you hold it to the contract date, you promise to sell whatever is being contracted for at the specified price. If you buy the contract and hold to that date, then you promise to buy. So being long or short on a future means exactly what the terms would suggest, that you are going to be long or short on the underlying in the future - whenever the date of the contract is for.

Now when it says "buy the asset", it means to buy whatever the underlying is now. So suppose the contract was for oil, if you were contracting to sell oil in December, you would buy oil now. That way when it comes time for you to sell oil as promised, you already have it ready to deliver. (You are "short against the barrel" so to speak.) Then, all you have to do is pay storage costs for a short period of time until the contract date, and then you deliver the oil that you bought for the price agreed to in the futures contract. Since the contract is for a higher price than you bought for, after subtracting your carrying costs hopefully you have made a profit. These carrying costs can be why the futures price doesn't quite meet the spot price.

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  • Thanks! So practically I am selling a contract for oil and at the same time buying the same contract for oil ? – GGGG Nov 15 '19 at 21:37
  • And benefit from the changes in price? – GGGG Nov 15 '19 at 21:37
  • By the way my textbook always explained that being in a short position meant selling the contact and a long position meant buying the contract... – GGGG Nov 15 '19 at 21:39
  • @GGGG no, you're only selling the contract and at the same time buying the actual oil in order to fulfill the requirements of the contract. you benefit by the current difference in price, minus whatever costs you have to hold the oil (or whatever) until you deliver it. it's arbitrage because one you execute the trade you have basically locked in this profit. – Michael Nov 15 '19 at 21:39
  • So even if I am in possession of short contract for oil , it still might imply that I don’t actually own the oil ? – GGGG Nov 15 '19 at 21:41

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