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Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.
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Video transcript
Every year this apple farmer produces one million pounds of apples. But he's got a problem. Every year the apple price jumps around a bunch. Sometimes it sells after the harvest for over $0.30, and this guy makes a ton of money per pound. And then sometimes it drops down to $0.10 per pound, and this guy can't even cover his costs. And on the other side of the equation, you have this pie chain right over here. So they specialize in making apple pies. And when the price of apples goes super high, these guys can't cover their costs. They start running a loss. But when the price goes really low, they have this kind of bonanza. But neither party here likes this scenario. They don't like the unpredictability of one year having a feast and then one year having a famine. So what they can do is, let's say we have the harvest coming up. The pie farmer is kind of afraid. Well, what if the price of pies goes back down to $0.10 per pound? Then he's going to go broke. The pie chain is afraid. What the price of pies goes up to $0.30 a pound? Then these guys are going to go broke. So what they can do is agree ahead of time, regardless of what the actual market price of pies ends up being after the harvest, they could agree to transact at a specified price. So they could set up a little contract right here. So they could set up a contract where the chain agrees to buy one million pounds at a specified date,-- let's just say after the harvest-- at the harvest for $0.20 a pound. This works out well for the chain because regardless of what the market price ends up being, they can ensure that they will pay $0.20 a pound, which is a good price where they could make a decent profit and at least they have the predictability and they can plan on things. And it works out for the farmer because he knows that a $0.20 a pound, he can cover his costs and pay his rent and pay his employees and feed his family. And it also takes out the unpredictability, the volatility for him as well. So what we have set up right here is actually called a forward contract. This is a forward contract. And what it is, as you can see, is in agreement and it's an obligation for both parties to transact in the future at a specified price. So at the time of this harvest when they write this contract, they would specify this date-- I don't know what it might be-- November 15. And at November 15, this farmer is obligated to deliver million pounds of apples. And then this pie chain is obligated to produce the money, to pay $0.20 a pound or essentially produce $200,000. And that way, they both are essentially able to avoid the volatility and make sure that they can survive.