Motivation for the futures exchange
About this video
The video explains why a futures exchange is willing to take on counter party risk: it can profit from the spread between what buyers pay and what sellers receive. It also introduces margin, money each party sets aside so the exchange is protected if prices move against them.
You'll be able to
- explain how a futures exchange makes money from the spread between buyer and seller prices.
- calculate the exchange's profit per contract from a price spread.
- describe what margin is and why the exchange requires it.
Key words
- Counter party risk
- The risk that the other side of a contract will not meet its obligation.
- Futures Contract
- A standardized agreement, traded on an exchange, to buy or sell something at a set price on a future date.
- Settlement price
- The price per unit that is paid when the futures contract is settled.
- Spread
- The difference between the price buyers pay and the price sellers receive, which the exchange keeps.
- Margin
- Money each party must set aside as a cushion in case the futures price moves against them.
Transcript
Male voiceover: You might be wondering why the exchange would be willing to take on the counter party risk for people trained, exchanging these kinds of standardized Futures Contract. The first reason is that the exchange actually stands to make a lot of money.
What he can do is tell these people who wanna buy apples in the future, he could say for example, "Hey, you can enter into a Futures Contract " with a settlement price of 22 cents per pound." So that's what they're going to have to come to the table with. That is 22 cents per pound and he could tell the people who are gonna deliver the apples that when you deliver the apples, the settlement price is 20 cents per pound.
Essentially, when the settlement occurs, he's going to be able to make a 2 cent profit. Let me review that again. If he only has to pay these guys 20 cents a pound for the apples, and these guys are paying 22 cents a pound for the apples, maybe I should make this arrow go in this direction because this is the flow of the actual money.
If these guys are going to pay 22 cents for the apples and then as the exchange, this guy only has to give 20 cents to the farmers, he's going to make 2 cents profit. On Futures Contracts, on 1,000 pounds of apples that's going to be $20 for each of those contracts.
That's going to be $20 per contract and he's going to be doing this night and day, trading with all of the different farmers and all of the different customers and even some speculators who might wanna do this. So maybe if the spread, if we kind of can maintain this 2 cents spread, he'll keep making $20 every time one of these Futures Contracts exchange hands.
Now, the other way that he's going to protect himself against losses is he's going to make each of these parties set aside some money in case, the Futures Contract price moves against them and this money that they have to set aside is called Margin and I'll explain this in more detail in the future video but what it essentially is, is the amount of money that this guy or the largest amount that this guy thinks that the Futures price might move by, the contract price might move by any given day and so, he has a cushion.
He can actually use the margin as kind of insurance so he can make sure that on the settlement date, both parties will kind of be able to meet their obligations. I'll go into more detail with that on the next video on exactly how margin works.
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