If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content

Verifying hedge with futures margin mechanics

Verifying Hedge with Futures Margin Mechanics. Created by Sal Khan.

Want to join the conversation?

  • blobby green style avatar for user Erika C.
    How do speculators play into this? I thought speculators were responsible for incurring some of the risk involved by promising to either pay the difference between the forward contract price and the actual commodity price when prices rise or keep the difference when prices fall. I don't understand the role of speculators if futures markets are marked-to-market and buyers and sellers are responsible for paying the difference themselves after margin calls are made...
    (12 votes)
    Default Khan Academy avatar avatar for user
    • spunky sam blue style avatar for user Mike Moyle
      People who own futures frequently sell them before the due date. In the example here, suppose the pie factory has a slowdown and decides in August that they are only going to need 950,000 pounds, instead of a million, in November. They would sell 50 of the futures to some other apple user, perhaps a grocery store who isn't sure they have enough apples coming in November, for whatever the going price for apple future contracts is. Or perhaps a speculator sees the offer to sell the future on the market, and thinks the price on the future is a bit too low, so he buys it and holds it for a while. If he was right, the then speculator will make money on the deal when he sells it. If he was wrong, then .... tough. Speculators have a bad name, after all they do not grow apples or make pies, but they do tend to keep the market active, which is a good thing.
      (11 votes)
  • blobby green style avatar for user sweeneyr82
    What prevents one of the parties from not topping up their margin accounts if the market price moves in their favour?
    (4 votes)
    Default Khan Academy avatar avatar for user
    • blobby green style avatar for user AndrewjKnott
      If you do not top up margins, you can be forced by the exchange or brokerage to "close out" of your position and lose the margin that you have put up. This is called a sell-out. If you originally bought a futures contract, it would be sold. If you sold a futures contract, it would be bought. You would be left with your margin losses neither the exchange or the person on the other side of the contract (counter party) would lose out.
      (17 votes)
  • piceratops ultimate style avatar for user Mike Xie
    Why can't you just get rid of marking to market and margins? It seems like more of a hassle anyway. In the end, both the farmer and pie company ended up with what was on the future agreement.
    (3 votes)
    Default Khan Academy avatar avatar for user
    • blobby green style avatar for user Mahesh Ramasubramanian
      Thats true, but if there was no marking to market and margins, there's no guarantee that the Pie Chain would have paid up the entire amount of 200$ if say apple prices had dropped to 0.10$ on or before Nov 15th. Let's say the apple prices did actually fall to 0.10$ and the Pie Chain found an alternate apple farmer/seller. The Pie Chain would just pay 100$ to the new farmer, and renege on his obligation to pay the original farmer. Having margins and marking to market prevents such cases where the contract is not honored by the two parties. So no CounterParty Risk as Sal initially explained. Hope this explanation is right/makes sense.
      (6 votes)
  • blobby green style avatar for user Shineel Tilwani
    i understood how margin works...but then i dont know how people make profits in futures...because ultimately you are just reducing your volatility risk...so if u have already decided the price at which you will buy or sell and the change thereafter is deducted/added to/from the margin....how are you making a profit?...Can you please explain this a little more in detail.?
    (4 votes)
    Default Khan Academy avatar avatar for user
    • leaf green style avatar for user ll.kishan.ll
      Well, the agreed upon price would inherently ensure a profit for both parties. The point of a futures contract is not to let one party gain more of the profits, but to ensure that both parties get the same deal, irrespective of the market's mood swings.

      If, however, you were a speculator, you could actually make an extra profit. For example, if your future's contract let you buy a thousand units of something at a later date and those units actually went up in value, you could sell those units on an exchange after the future's contract is carried out. In that case you would have bought 1k of something at a cheap price, even though it ended up gaining value.You could then sell those units to profit the difference.
      (8 votes)
  • blobby green style avatar for user mullachv
    Do the margin accounts gather interest?
    (6 votes)
    Default Khan Academy avatar avatar for user
  • blobby green style avatar for user piyushpasari246
    a seller sold the future initially at say$200 and earned margin as rate fell to $100.what if the production of apple falls and there is not enough apple in the markets to satisfy the futures sold?obviously the seller will call out but do he need to pay back his margin earning.
    (1 vote)
    Default Khan Academy avatar avatar for user
    • leaf green style avatar for user Ryan
      All futures, including those calling for delivery, are eligible to be settled in cash. This is to protect the exchanges from default. If the world literally runs out of apples, the contracts will still be honored and whoever is holding the contracts at delivery will get a cash settlement equal to current market prices.

      Very few contracts (about 2%) are actually settled through delivery of the underlying commodity. Most are settled in cash.
      (7 votes)
  • leafers ultimate style avatar for user Mario Catalin
    Someone explain me how would the Buyer benefit from all this, if he could buy the apples he needs at the end with only 100 dollars? I think i'm missing something. For me it seems that the only one who would benefit is the seller.
    (2 votes)
    Default Khan Academy avatar avatar for user
  • blobby green style avatar for user Mahesh Ramasubramanian
    How would time value of money be taken into account here? If the margin of 10$ is taken from the buyer and given to the seller when the price fell to 190$, the value of the 10$ received by the seller today is more than the 10$ (of the total 200$) he would have received on the 15th of November?
    (3 votes)
    Default Khan Academy avatar avatar for user
    • blobby green style avatar for user joshdance
      The forward curve for the futures contract will take into account interest/dividend yield, cost of storage, financing, and any other factors which make it advantageous or disadvantageous to hold the commodity until delivery date. In this example, a further out contract (say, December 15) will likely cost more to enter into today than a November 15 contract. Why? Because the seller (farmer) will charge a premium to store the apples. And, the cost will be higher because of what you said, since the TVM will allow the buyer to invest money in that extra month for a profit. The December 15 contract would take these into account and typically will be higher.
      (1 vote)
  • blobby green style avatar for user arun.karthika
    What if the farmer had very bad cultivation (due to natural causes) and he couldn't deliver the 1000 pounds of apple?
    (3 votes)
    Default Khan Academy avatar avatar for user
  • blobby green style avatar for user Alex D
    What is the point of making these contracts exchangeable if the whole point to have them originally was to match up buyers and sellers of a commodity who wanted to avoid volatile trading markets and lock in a set price? Set and forget? The tradeability seems to be at odds with this attitude. The buyers and sellers in these contracts weren't supposed to be 'watching markets' looking for a quick profit, they were looking to build their businesses in a sustainable, less volatile way. The market has perverted the original intent of these contracts.
    (2 votes)
    Default Khan Academy avatar avatar for user
    • male robot hal style avatar for user Andrew M
      The purpose is to match up anyone who wants to buy with anyone who wants to sell, not to match a specific buyer with a specific seller. The market would be much less liquid if people could not trade. It's no different than the stock market in that regard.

      Buyers and sellers who want a non-tradeable contract are certainly free to enter into that, but that would have nothing to do with an exchange, who's entire purpose is to enable trading.

      Trading provides valuable price information, by the way.
      (2 votes)

Video transcript

Let's verify that the margin mechanics in the marking to market of the futures contract actually gets both the seller and the buyer what they originally wanted, which is that they don't have to be susceptible to the volatility in apple prices. They both wanted to, effectively, sell the apples for $0.20 a pound or buy the apples for $0.20 a pound. And they didn't want to, in the farmer's case, go out of business if they could only sell the apples for $0.10 a pound, or in the pie company's case, go out of business if they had to buy the apples for $0.30 a pound. So let's verify that this works out. So they originally had a contract price of $200 for 1,000 pounds. So this is essentially $0.20 a pound. And as we said in the previous video, as the futures contract delivery price changes day by day, as we get closer and closer to the actual delivery date, what happens is that we transfer money between the buyer's margin account and the seller's margin account. As the delivery price of the future contract goes down, in order to mark the delivery price down-- so in order to mark it down from $200 to $190 to $185-- this guy keeps getting a better deal on the actual delivery price. So to make things fair, he has to transfer the same amount of money to the margin account of the seller. So let's imagine two scenarios. Let's say that eventually, as we approach November 15-- remember, this is the delivery date-- the futures contract delivery price is going to approach the market price. You can imagine right when we're like a second before the delivery date, the futures contract and the market price aren't going to be that different. And let's say that this goes all the way down to $100. So in that whole process, this futures contract keeps getting marked down to $100. So on that day, it is true that the seller will sell 1,000 pounds of apples to the buyer for only $100. You might say, hey, wait. What did the seller get out of this? He's only getting $0.10 per pound for his apples. This was what he feared. He is susceptible to the volatility of the market prices. But remember, because of this marking to market, and because of the margin transfers here, as this delivery price went down from $200 to $100, there would have been a transfer from this guy's margin account to this guy's margin account of $100. So instead of just getting the $100 for that 1,000 pounds of apples, because this seller had this futures contract, he would have also gotten another $100 transferred into his margin account. So the true economic value he gets is $200, no matter what, for his 1,000 pounds of apples, or $0.20 a pound. You can imagine the other scenario. What if the delivery price as we get closer and closer to delivery date goes up? If it goes to $300 per 1,000 pounds? Well, you might say, hey, the seller is going to get a bonanza, and this guy's going to go out of business because he's going to be essentially paying $0.30 per pound. But you gotta remember, if the price went up and it becomes more and more favorable to the seller, because of the margin mechanics, the seller would have to transfer $100 over-- as the price moves up-- to the buyer, to his margin account. And so even though this guy has to pay $300 per pound, because that's where the market price eventually ended up, he would get $100 from the seller. So effectively, he would still only have to pay $200. And even though this guy is selling it for $300, he actually had to pay another $100. So net, he's really only getting $200 for it. So no matter how you look at it, both parties are transacting at $200, or $0.20 a pound.