Verifying hedge with futures margin mechanics

0:00Let'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.

0:23And 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.

0:39So 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.

1:00As 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.

1:20So 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.

1:38And 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.

1:58What 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.

2:25So 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.

2:45You 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.

3:04But 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.

3:28So 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.