Another video clip: the story of indian cows…
It’s like the range of uses for cows in economic examples is unlimited.
The basic summary:
- A derivative is just an agreement where we decide on a price today, for a product that will be delivered at some future point in time.
- In some ways, it’s a bit like shopping online. I pay today, and I take delivery in 5-7 working days. If the product goes on sale in two days time, it’s too bad for me – I’ve already agreed on a price.
- It’s especially important for farmers, who invest all their money in rearing a cow (or growing a crop) today, hoping to sell it in a year’s time.
- So they go out to the market, and agree to sell the cow at a certain price in a year’s time.
- And one year later, the farmer hands over the cow to the buyer, and the buyer hands over the agreed-upon cash.
- If the market price of cows at that point is higher than the contract price, then the buyer has scored a bargain. If it’s lower, then the buyer has suffered a loss.
For the record, I kind of disagree with the video clip’s premise that mad cow disease would cause the price of cows to drop. It could cause it drop, if people suddenly stopped demanding beef (in India – did they ever want it?). But it could also cause the price of uninfected cows to shoot up.
The real reason that farmers want to sell their cows (or crops) in advance is not for fear of natural disasters (that’s what insurance is for) – it’s in case there is suddenly a bumper year. Because when there’s a bumper crop, the price falls with the overabundance of supply…