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Main content
Current time:0:00Total duration:3:29

Video transcript

after the farmer and the pie Jane and it get involved in this forward contract a few questions start to pop up in each of their minds the main one is what if the other party isn't able to uphold then their end of the contract and this is called counterparty risk counterparty risk which is essentially the counterparty to the farmer is the PI store and the counterparty to the PI chain is the farmer and it's the risk that the other party won't be able to uphold their end of the contract the other thing that starts to worry either one of these is what if they start to have second thoughts about this forward contract that they entered into would they be able to maybe sell their obligation to someone else so is there any way to trade to trade the contract and then there's another issue that even if you were to trade the contract how do we know that the other party to the whoever you might want to trade with would be cool with a million pounds or two hundred thousand dollars maybe they would want to deal with a smaller quantity maybe they would only want a thousand pounds or $100,000 worth of apples so the local the local brain comes up with an idea he's like why don't we standardize these forward contracts why don't I just create a bunch of contracts whenever someone wants to enter into one of these forward contracts but I standardized them and I say that it is a thousand instead of having a million apples I do a small enough increment so I say a thousand pounds of apples apples for delivery for delivery on let's say November on November 15th and every one of these contracts say the same thing a thousand pounds of apples for delivery on 1115 and this guy he's also the richest guy in town he's already been running a stock exchange and so to to help alleviate the counterparty risk fear he also says that I'm going to guarantee I will guarantee any of these any of these contracts so essentially he's taking on all of the counterparty risk to make people more comfortable with trading so all of a sudden what happens is is that now these guys don't have to do a one-off contract they don't have to do this one-off forward contract there are these standardized contracts that this exchange can now trade and what happens is is that smaller farmers so small let me do this in a different color you have farmers farmer a farmer B farmer B can now can now transact with I should say I guess we could call it customer customer C and customer customer D where they could agree to have a fixed price but they could do smaller increments more granular increments and if any of them want to get out of it they can by selling their contract to another person on the exchange and these more standardized forward contracts they're still essentially the same thing they're just standardized their agreements to transact at a future date give a certain amount of money for a certain amount of something else it could be a security it could be apples these things these standardized forward contracts these are called these are called futures where they're standardized and they are traded on an exchange