Current time:0:00Total duration:3:29
0 energy points
Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.
See 7 lessons
Video transcript
After the farmer and the pie chain 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 their end of the contract? And this is called counterparty risk, which is essentially, the counterparty to the farmer is the pie store. And the counterparty to the pie chain is the farmer. It is 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 they entered into. Would they be able to maybe sell their obligation to someone else? So is there any way 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 $200,000. Maybe they would want to deal with a smaller quantity. Maybe they would only want 1,000 pounds or $100,000 worth of apples. So 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 to one of these forward contract, but I standardize them. And I say that it is 1,000, instead of having a million apples, I do a small enough increment. So I say 1,000 pounds of apples for the delivery on let's say on November 15. And every one of these contracts say the same thing. 1,000 pounds of apples for delivery on 11/15. And this guy, he's also the richest guy in town. He's already been running a stock exchange. And so to help alleviate the counterparty risk fear, he also says that I'm going to guarantee 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 that now these guys don't have to do a one off contract. They don't have to do this one off the forward contract. There are these standardized contracts that this exchange can now trade. And what happens is that smaller farmers. Let me do this in a different color. You have farmer A, farmer B. Farmer B can now can now transact with, I should say, I guess we could call it customer C and 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. They're 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 futures, where they're standardized, and they are traded on an exchange.