 Hey guys, it's MJ the student's act tree and in this video. We're going to be talking about subject CT2 Chapter 5 which is all about the use of derivatives Now I have made a few videos already on derivatives specifically forwards and futures and that's under my CA1 playlist so go find it there for a more comprehensive View on what derivatives are and all that type of stuff. So what I'm going to do bearing in mind that we have that video I'm going to keep this video very short and just talk about the general features But like I said go check out that other video. I will put a link in the description But that further ado, let's jump into it I'm going to talk about a forward a future an option and a swap and then I'm going to talk about the use of derivatives with regards to risk management and how it can reduce the cost of borrowing But let's go straight into it. So a forward contract or let's actually maybe take a little step back How these derivatives came into existence was with farmers So farmers is one of the areas where futures and forwards started the idea was that a farmer comes and he plants his crop and He has to wait a whole year or a whole season before he can harvest those crop and take it to market Now when he takes it to market He doesn't really know what the price is going to be So if he's planting apples or wheat or something like that The price could be 10 ran for wheat or it could be 20 ran for wheat or it could be 5 ran for wheat and Because of this uncertainty The farm is in a little bit of a problem because let's say there is a 50% chance that the price of wheat could be 10 ran and there's a 50% chance that the price of wheat could be 5 ran so it's either 10 ran or it's 5 ran and the farmer looks at his Looks at his books and he sees oh my gosh. It costs 6 ran per per wheat Order to grow know the cost of labor the tractors the irrigation all that he sees that his costs are 6 ran and Let's get him a little bit of a problem because this means that There's a 50% chance that the wheat will be less than what it took to make it and He will therefore be bankrupt in the sense that he won't have enough money to cover all of his costs and There's also a 50% choice that he gets it for 10 ran and he becomes incredibly wealthy So he's in this predicament. He doesn't like this uncertainty When all of a sudden a financial genius comes up to him and he says to the farmer. He says listen here 10% 50% chance is going to be 10 ran and there's a 50% chance is going to be 5 ran This means the expected cost is going to be 7 ran and 50 cents But all you need to do is sell your wheat at a price for 6 ran or more in order to make a profit I Will therefore buy your wheat at a guaranteed price of 7 ran So farmer looks at this and he's like well, this is actually a good deal I'm now reducing my risk and I'm locking in a price at 7 ran, which means the cost of my wheat is 6 ran I'm guaranteed a profit of 1 ran and this is good because it means next year I can plant again for 6 ran, but I will have made 1 ran profit per chunk of wheat The financial genius he's also quite happy because he knows statistically. He's making 50 cents on this deal Something that has an expected value of 7.5 ran and he's getting it for 7 ran so in this case both parties are happy and What happens is if the market is at 5 ran at the end of the year the financial genius loses 8 on 2 ran per wheat But there's also that 50% chance that it could have been 10 ran and he could have made 3 ran On the wheat and if he does this every single year year on year out He can he knows that he's gonna make profits in the long term Now what we do is we call this thing a forward contract and the word forward is because We're making a deal in the future. Well, it's forward. It's you know, it's not now We're gonna be doing it later. You know, you need to fast forward to that date So a forward contract is a contract to trade an asset at a fixed price at a fixed date in the future So in our example the fixed price was 7 ran and the asset Was wheat and the fixed date is the following year Now what the farmer could do or what the financial genius can do is they can create something called a Future contract now a future contract is different to a forward contract in the sense that a future contract is a standardized marketable contract to trade an asset at a fixed price at a fixed date in the future so what this means is a Forward contract is very customizable It's between the the farmer and it's between the financial genius and they could make it for any Quantity amount on any certain asset whether it be wheat apples oranges or something like that the future contract Standardizes a few of these parameters and the reason for doing so is it makes it much more marketable and you can now open up an exchange and There's a lot of benefits to this you lose out on some of the custom Ability of it, but you're making up for it in marked ability. There's a whole secondary market in which you can trade these assets and Now a financial future is a contract that is based on an underlying financial instrument rather than a physical commodity So the financial genius can take the same ideology and instead of approaching farmers can approach Banks and say let's Create a financial future on interest rate payments or whatever financial Instrument they want to lock in at a future date Now there's something else I want to talk about and that is an option Well, I don't know shit. Let me let me actually end this video here on The the forward and the future and we'll make another video on the option Otherwise always these videos are gonna be way too long. So yeah, this is ready at seven minutes so I'm gonna end the chair and We're gonna continue chapter five in another video. So subscribe for that, but it should be posted up at around the same time