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!