So let's now get even more primitive.
Go back and ask yourself,
"Long forward, short futures.
What are the cash flows involved in something like that?
What are the cash flows involved in something like that?"
This is a money and banking class so we're always thinking about that.
Long forward, and we're talking here about
a case where the long side typically wins
because of the failure of the expectations hypothesis.
Okay. So long forward means you're going to win,
probably, okay, but not right away and you won't get any cash until the end.
Okay. Long forward means, okay,
probably cash flow at time T. Probably.
You know, there's uncertainty about this but that's what...
And short futures, okay,
means probably you're going to lose, okay?
But you're going to lose all the way along, okay?
Okay, you're going to have negative cash flow until time T, okay?
All your losses are going to be between now and time T.
So probably negative cash flow now,
okay, now and until T, okay?
Again, there's going to be fluctuation,
that's why I showed that picture.
Sometimes you'll be winner sometimes you'll be,
but you're expecting that you're probably going to be,
you're probably going to be having to come up with some money, okay?
Cash money, settlement, survival constraint money,
collateral to keep in this game.
If you can't keep in this game the clearing house will liquidate your position.
That's the whole point of these margin, margin requirements.
So what about this now? What about this now?
This position full carry pricing says there should be no,
there should be no profit here.
But when you think about the cash flows, you say to yourself, "Well,
this purse, this is not a risk free position,
okay, there's liquidity risk here."
In fact, we've gotten,
we've gotten rid of all the risk except liquidity risk.
This is, in fact, this is perfect pricing of liquidity risk.
We've gotten rid of all the price risk.
There's only liquidity risk here because we're going to have
cash flow adequate enough to pay for
all these negative cash flows but not at the same time, not at the same time.
This is only a risk free position if we are quite
sure that the certainty of this is going to let us pay that, okay?
That we can somehow use this to pay that.
Which is not really possible because it's not certain,
you know, at the end of the day.
We're fully hedged and yet we're facing liquidity risk, okay?
So what we're seeing here is that this banking point of view, okay,
that helps us understand why the expectations hypothesis fails, okay,
because there's an imbalance in the forward,
in the forward market that pushes that re-price away from the expectations,
from the expected spot rate.
This same way of thinking, okay,
helps us to understand these very confusing pages in Stegun,
okay, where she talks about the cash and carry arbitrage, okay?
Which implies, although she hasn't got the analytics all that clear, okay,
implies that forwards and futures aren't trading at the same price even
though we have a formula that makes them interchangeable with each other.
Okay. Now, an aside,
just so we make sure that we're getting the correct point here.
The difference between forwards and futures is that
one pays at the end and the other pays all along, okay?
So you might think that there is
a reason why their price would be different from each other because as,
if you're getting paid all along or you're paying all along then you can reinvest that,
those payments, okay, which you can't do in the forward, in the forward contract.
There's no, no reinvestment in accumulation.
People have tried to use this theory, okay,
to explain why forwards and futures have different prices,
okay, but it doesn't work.
It goes in the wrong direction actually.
So, in fact, that feature may be responsible for not seeing how big this cash,
how big this liquidity premium is, okay,
because the reinvested short term money that you get for, from the,
from the forwards moves
the price of the futures away from forwards in the opposite direction.