Assignment 5 - Name_ Food & Resource Economics 3103...

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Name_______________________ Due Date : 11/24/10 Exercise 5 A. Arbitrage is the practice of simultaneously buying and selling a commodity in two different markets with the intention of profiting from the price difference in the two markets. Arbitragers in futures markets are part of the group of traders known as speculators--they are the grease that makes this machine work efficiently. Arbitrage can occur in any two markets separated by time, place and form. Here is a simple example of each. Temporal arbitrage . The monthly cost of storing corn is about $0.03 per month. Slick Willie notes that in December the current cash price of corn is $2.50/bu and that the March futures price is $2.80. He buys corn in the cash market and simultaneously sells a March futures contract. In March he makes physical delivery as specified in the contract. His costs are $2.50 for the cash corn and $0.12 for four months of storage. He receives $2.80 in March for a profit of $0.18 per bushel. Spatial arbitrage . Willard Fillmore is a truck driver. He really has nothing planned for this Wednesday, so he gets on the net and finds that the cash price of corn in Ames, Iowa (where he is currently working towards a B.S. in truck driving) is $2.30 per bushel and the cash price in Chicago is $2.50/bu. He figures his cost of hauling a bushel of corn from Ames to Chicago is $0.12 per bushel. Thus, he buys a truckload in Ames and drives it to Chicago where he sells it for $2.50. His costs are $2.42, so he earns a clear profit of $0.08 per bushel. [Note: to avoid an empty backhaul he buys a truckload of beer in Chicago where liquor taxes are very low and hauls it back to Ames where they are very high. While this is highly illegal, it is spatial arbitrage nonetheless.] Commodity arbitrage . Smoothie Sussie is a speculator at the Chicago Board of Trade. She has learned that over time, the price of futures contracts for soybeans (in cents/bu) are typically three times that of the price of futures contracts for soybean meal (in $/ton). That is, when the price of a soybean contract is 600 cents/bu, the price of the soybean meal is usually $200/ton. One day Sussie notes that soybeans are trading at 800 cents/bu and meal is trading at $400/ton. Sussie
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Assignment 5 - Name_ Food & Resource Economics 3103...

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