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.