i guess i'm not being clear here... I understand that futures and stock converage at the time when the futures expire... but when you trade say the ES, unlike options... you aren't obligated to deliver 500 stocks to the person who is buying the contract from you. Correct me if I'm wrong, but it's like we artifically create a seperate value price of SPX when creating an ES contract. One does not affect the other... say if someone bought all the ES contracts and the price of ES is 100 points more than SPX.... SPX is not affected it only is affected when investors "want it to" by having them converge back together which would take the investor to short ES and long SPX. What I'm saying is that, what causes them to converge besides the fact that people assume and force them to converge? is there some sort of benefit to getting them converge besides... you'll only make a profit if others are will to get them to converge too... but why must they converge?? it's not like say corn, if you don't converge then one can accept delivery and then go out to an area and sell your cheap corn to make a profit... how would you do this with ES? The only place to sell ES is on the exchange... it's not like with corn, there are areas that might want to buy your cheap corn. Everyone trading the ES sees exactly the same thing on the screen...
You're absolutely right. One does not affect the other. If arbitrage were difficult or impossible to perform, it's conceivable that ES would float in *dramatically* different directions from SPX. In the case of ES, arbitrage is dead simple. If any derivative floats too far from fair value, someone will step in and move them back into alignment. After all, arbitrage is risk-free money--hundreds of people are happy to take free money. Even in commodities, right now NYMEX offers cash settled Cotton while NYBOT offers product settled Cotton. Cash settled is nice because you don't need to physically transfer (and inspect) anything when the contract is up. Cash settled is bad because it generally doesn't attract the true commercials in the market. Speculators trading only with other speculators makes for a pretty boring market. Cash settlement also has the benefit of allowing you to trade in things you don't really ever want. Eurodollars, for example, are priced based on a $1M deposit in a non-US bank. I don't really want to take delivery of $1M deposited in some foreign bank. I'd much rather have the difference between what I paid and what it settles at. In the case of the new Uranium contract, I may not even be legally able to accept delivery, but I can still participate in price movement because it's cash settled.
I don't quite understand how arbitrage is risk-free money... say if ES was 800 and SPX was 805... If I bought both ES and SPX.... what's to say that they won't just drift apart in price since they clearly don't affect each other? You mentioned that it's a benefit to have things cash settled... I can understand this that if you have corn and you want to convert it to cash, you have a buyers bidding on it... but what's to say that this will cause the market price to go up or down...I still don't get how this will naturally force a convergence...
Because, at expiration, ES settles at the cash value of SPX. http://www.cme.com/trading/prd/equity/settlement.html In other words, if you bought ES today at 50 points below the cash index, cash did not move at all between now and expiration, you would pocket 50 points. Your cash example for corn didn't make much sense. Cash-settled contracts don't have anything to do with farmers converting their crop into cash, that's what the spot market is for. Cash-settled contracts just means there is no physical delivery of an asset. A physically delivered ES contract would have you delivering all 500 stocks in the S&P 500 index in the right ratios. Since this is clearly unreasonable, the ES contract is designed to settle at the cash price of the index on expiration.
So you're saying that if I bought 1 ES contract right now... it will automatically be converted to the value of SPX even if I didn't choose to sell it on the expiration day?
you can not "choose" not to sell it, it gets settled in cash if you still have it left at expiration day.
Right, much like you would own 5000 bushels of corn if you did not sell a long corn contract before expiration.