Welcome to professorsavings.com, we teach daily money saving videos. Today we will teach you how do futures contact works.
Hi I’m Rayfil Wong. The concept today will teach you to lock down on prices especially if you’re a restaurant who buys in bulk. A good example, an own of a major donut franchise.
A futures contract can protect producers and suppliers from price changes.
Ray’s Donut buys sugar from Jane’s plantation to make donuts. The price is $1 per pound. At this price, Jane’s profits from the sugar it sells and Ray’s profits on every donut he sells.
One day, a new sugar plantation and the number of sugar plantation doubles. The extra sugar pushes the price of sugar down to $.50 per pound. Ray’s is making more profit as cost drop but Jane’s is losing money.
Later, a hurricane knocks out half of the sugar fields.
Sugar rises to $5 per pound and Ray’s profit per donut disappears.
Both companies want to avoid this price volatility or instability.
They both meet with an investor.
Each company negotiates a separate contract with the investor.
For Jane’s Sugar, the contract states that if the price of sugar goes below $1, the investor agrees to pay the difference to Jane. If the price goes above $1, the investor gets to keep the profits.
Ray’s contract with the investor works the opposite way.
If the price of sugar goes above $1, the investor pays the extra money and Ray’s gets sugar at a predictable $1. If the price dips below $1, Jane still pays $1 and the investor collects the profits.
By locking in the price of sugar, a futures contract allows both Ray and Jane to transfer their potential risks and rewards on the investor.
Simple enough right?