Comment by Utkarsh_Mood
3 years ago
> On the other hand, if he's a good farmer, and the farm produces well, and he doesn't over-extend his risk on what he's committing to, he now has a fixed price contract for his goods, which isn't going to fluctuate based on time (assuming the contract is honoured - if he's worried about that, Jeremy could then buy insurance on the risk of a default on the contract
So basically a third party would step in to assure him that he'd be paid the fixed price for a small fee? Are there no repercussions if the contract isnt honored?
I mean, shit is still going to hit the fan if the contract isn't honoured, but in the simplest terms, yes, he'll still get paid by the insurer if the contract party defaults on the contract. (As a massive scale version of this, see 2007/2008 financial crash. That's basically what happens when counterparties default at scale and insurance contracts have to pay out everywhere, to the level that the insurers themselves have to be rescued.)
Simple example - let's say the contract is for 100 tonnes of wheat at £175 a tonne. So Jeremy should get £17,500 for the wheat he's contracted to deliver. Now let's say that Jeremy has the 100 tonnes ready to go, but the flour merchant can't/won't pay up. Maybe he's in financial troubles, maybe Jeremy ran off with his wife, who knows. But for whatever reason, he refuses to pay.
Now let's also imagine two scenarios - one in which the price of wheat has gone up, and one where it's gone down. In the former, Jeremy is actually happy with this, as he can now sell his grain on the open market for more than the contract, and claim the insurance payout on the contract. On the other hand, if the price went down, Jeremy still has to sell his grain, but he might only get £100 a tonne, which is going to result in a loss of £7,500. At this point Jeremy is very glad of the insurance.
Now the interesting bit is the insurer has the estimate the risk of default, and the likely movement on the market, to be able to offer a sensible insurance product to Jeremy. So Jeremy might pay £1,000 for an insurance product which pays out £10,000 on the default of the purchaser, for example. Obviously the numbers involved here are fictional (apart from the price of wheat per tonne, which is probably around the mark given at the moment), but the principle is accurate.
> Are there no repercussions if the contract isnt honored?
Basically the entire point of futures markets is to standardize the contracts and process by which these contracts are fulfilled to the point where all of that is just part of the pricing mechanism.