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Finance and capital markets
Course: Finance and capital markets > Unit 9
Lesson 2: Forward and futures contracts- Forward contract introduction
- Futures introduction
- Motivation for the futures exchange
- Futures margin mechanics
- Verifying hedge with futures margin mechanics
- Futures and forward curves
- Contango from trader perspective
- Severe contango generally bearish
- Backwardation bullish or bearish
- Futures curves II
- Contango
- Backwardation
- Contango and backwardation review
- Upper bound on forward settlement price
- Lower bound on forward settlement price
- Arbitraging futures contract
- Arbitraging futures contracts II
- Futures fair value in the pre-market
- Interpreting futures fair value in the premarket
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Forward contract introduction
Forward Contract Introduction. Created by Sal Khan.
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- What happens if the farmer has a bad harvest and doesn't produce a million apples? Does he have to buy them from someone else to give to the pie shop owner?(24 votes)
- OK, Sal answers this in the next video.(26 votes)
- Is it compulsory for both the parties to execute the contract?(5 votes)
- Yes, hence the word contract, or otherwise one side of the contract would have breached the contract. Unless both parties agree to nullify the contract.(3 votes)
- What happens if the farmer has a bad harvest?(3 votes)
- That would be something written into the contract. What would be the provider's responsibility if he can't deliver the apples, what would be the pie makers responsibility if they can't pay...all that is agreed to beforehand in a futures contract(2 votes)
- Sir, can three or more parties be a part of forward contract?(2 votes)
- We have a buyer and a seller. What would the third party be there for?(2 votes)
- If I enter into a contract with a delivery, who pays for the delivery costs? The buyer or the seller? Let's say I enter into a contract for a few tons of coffee, I guess that the delivery cost isn't negligible.(1 vote)
- The delivery terms are set in the contract. The contract is for delivery to a particular place. That's where you pick it up. If you want it delivered somewhere else from there, you cover the cost.(2 votes)
- Does this Contract ac as Insurance on the price and quantity both parties - the farmer and the chain - agree to pay for and get from each other. regardless of market price fluctuations of the product ?(1 vote)
- Too add real value to these lecture, a questioner/multiple-choice/exercise must follow; otherwise, it's just another YouTube video with little academic value.(0 votes)
- What are different in Options, Forward and futures contracts?
Option: The buyers can easily buy and sell without third party in the market
Forward: Can be negotiated by transacting parties and only the argreement between 2 parties. Transacting parties assume the counterparty risk.
Futures: Be standardized
Traded on the exchange and hence can be bought and sold to others.
Do not expose to counterparty risk. Exchange assumes it.
Why futures contract is more suitable being a speculator than forwards contract?(0 votes) - why it must $0.20 why it cannot be $0.10 or $0.30(0 votes)
- He just used $0.20 as an example. In an over the counter (OTC) transaction between 2 parties they could agree on any price they wanted. If both parties though that apple prices were going through the roof next year, they could have agreed on $0.40/lb. On the other hand, if they thought there was going to be a bumper crop next year and a supply glut, they might have agreed on $0.07/lb. If you want a good comedic look at this stuff, try Trading Places (1983) with Dan Aykroyd and Eddie Murphy. It's not necessarily accurate and definitely not up-to-date, but it's pretty funny.(5 votes)
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.