What is the process that makes sure the market price of an underlying asset equals the price of a futures contract at the settlement date? Provide an example.
What will be an ideal response?
The process that makes sure the price of the underlying asset and the price of the futures contract are the same at the settlement date is arbitrage. Arbitrage is the process where an individual earns a profit without incurring any risk. For example, let's say one year before the settlement date the futures price for delivery of a 5 percent 10-year coupon bond is $1,100. Currently the spot market price of the bond is $1,000 and the investor can borrow at 5 percent. An investor could borrow $1,000, purchase the 10-year bond, and sell a bond future for $1,100 promising delivery of the bond in one year. The investor can use the interest payment on the bond to pay the interest on the loan and deliver the bond to the buyer of the futures contract on the delivery date. This transaction is riskless and nets the investor a profit of $100 without putting up any funds.
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