Doing the example with accounts payable growing

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Language: en

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In the last series of
examples, we go into month two

00:00:03.390 --> 00:00:05.024
with $100 in cash.

00:00:05.024 --> 00:00:06.440
And the way we set
up the example,

00:00:06.440 --> 00:00:07.959
we spend $200 in month two.

00:00:07.959 --> 00:00:10.000
And what we've been doing
so far is we're saying,

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oh, that gets us to a cash
balance of negative $100

00:00:14.260 --> 00:00:15.797
at the end of month two.

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And that's a little unrealistic.

00:00:17.130 --> 00:00:18.629
I kept it simple
here, and I allowed

00:00:18.629 --> 00:00:21.570
us to have a negative cash
balance just for simplicity.

00:00:21.570 --> 00:00:24.114
But usually you will not
see a negative cash balance.

00:00:24.114 --> 00:00:26.030
The fact that you have
a negative cash balance

00:00:26.030 --> 00:00:28.220
and you're allowed to
operate, it essentially

00:00:28.220 --> 00:00:30.800
means that someone
is lending you money.

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So to make this example a
little bit more realistic,

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let's imagine a situation.

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So in month two,
you only have $100.

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The person that you're
catering for-- that you're

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buying these $200 of
supply for-- they're

00:00:41.900 --> 00:00:44.450
not going to pay you
until next month.

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So you tell the people that
you need to buy stuff from,

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look, I only have $100.

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I have this customer.

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I'm doing the catering
for them this month.

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Can I pay $100 to
you this month,

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and then maybe pay another
$100 to you next month?

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And let's say that
they agree to that.

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So in month two,
on a cash basis,

00:01:00.680 --> 00:01:02.830
instead of spending
$200, you're actually

00:01:02.830 --> 00:01:04.349
spending-- I'll
just write over it--

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you're actually spending $100.

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And then in month three,
you'll also spend $100.

00:01:12.730 --> 00:01:16.750
Now, this will change your
cash accounting numbers.

00:01:16.750 --> 00:01:21.284
This will now be negative 100
and this would now be $500.

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But the more
important thing is, I

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want to show you how
this could be accounted

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for in accounts payables.

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The fact that you essentially
told your vendors,

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even though you gave
me $200 worth of stuff,

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I'm only going to
give you $100 now,

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and I'm going to give
you $100 later-- that

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means that you've increased
your accounts payable by $100.

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You've increased this
liability that you owe things

00:01:42.530 --> 00:01:43.900
to other people.

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So let me add accounts
payables over here.

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So I will add it-- I'll add
it in a row-- I'll do it

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on both of these diagrams-- So
I'll just call it accounts--

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I'll just do A period,
so I don't have

00:01:54.090 --> 00:01:57.850
to write the whole
thing-- accounts payable.

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And going into the
period, you didn't

00:02:00.210 --> 00:02:01.501
have any accounts payable.

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And then now that
you're essentially

00:02:03.000 --> 00:02:04.810
borrowing $100
from your vendors--

00:02:04.810 --> 00:02:07.440
you're allowing to push
back when you pay them--

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You now have an accounts
payable of $100.

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And I'm not going
to work through it

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on all of this stuff over here.

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But let's see how that would
have affected the income

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statement and the
balance sheets.

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So over here, all
of a sudden, you

00:02:18.906 --> 00:02:20.890
had another liability--
accounts payable

00:02:20.890 --> 00:02:24.810
is a liability-- You
have an accounts payable

00:02:24.810 --> 00:02:28.980
liability of $100.

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So at this point, we had no
accounts payable liability.

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And then after the
end of the month,

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we have an accounts
payable liability of $100.

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We owe $100 to our vendors,
and our cash is now at 0.

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So notice it still does
not change our equity.

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We essentially
added $100 to cash,

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and then we added
a $100 liability.

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They cancel out.

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If you take now this part
right here, all of the assets

00:02:54.350 --> 00:02:54.850
are 400.

00:02:54.850 --> 00:02:58.410
400 400 minus 100
in liabilities still

00:02:58.410 --> 00:03:01.220
gets you to 300 in equity.

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But now the reconciliation is to
go from $100 in cash to 0 cash.

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We're not allowing
ourselves to go negative.

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And the reason why we can
do that is we actually

00:03:11.210 --> 00:03:14.650
have a source of cash.

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So let me erase
that, and then let's

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add a line right
down-- Let me see

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if I can add a line
right over here.

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So we could say accounts
payable increase,

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and now this is
a source of cash.

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And it might not be obvious.

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We're increasing a liability.

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But it's a source
of cash because we

00:03:36.080 --> 00:03:37.660
don't have to use our own cash.

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By increasing the
accounts payable,

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it's allowing us to not
use all of our cash.

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So we have an accounts
payable increase of 100.

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So this is a source of cash.

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So now the cash
from operations--

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200 net income,
minus 400 plus 100.

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This whole thing is now minus
100 cash from operations.

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So you start with
$100, you use 100.

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Our ending cash is now
0, and it all works out.


Basic cash flow statement

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In the last video, using the
accrual basis for accounting,

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we had $200 of
income in month two.

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But over that same
month, we saw that we

00:00:10.010 --> 00:00:14.550
went from having $100 in cash
to having negative $100 in cash.

00:00:14.550 --> 00:00:16.750
So we actually
lost $200 in cash.

00:00:16.750 --> 00:00:19.130
So how can we reconcile
the fact that it

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looks like we made
$200 in income,

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but we lost $200 in cash?

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And that reconciliation is going
to be done with the cash flow

00:00:27.870 --> 00:00:28.450
statement.

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So most cash flow
statements-- so I'm

00:00:30.695 --> 00:00:32.820
going to do a cash flow
statement right over here--

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so they'll start
with your net income.

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Or actually, they'll
start with the cash

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that you started out with.

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So they take you from this cash
balance to that cash balance.

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So they'll say something
like starting cash.

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Starting cash we
know is at $100.

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And then they'll say, well, in
the most naive interpretation

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of things, your net
income in theory

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should be cash you're
getting or at least it's

00:00:56.440 --> 00:00:57.370
some type of profit.

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You're getting some
assets in the door.

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Or at least you're
counting as if you're

00:01:01.000 --> 00:01:02.800
getting some assets in the door.

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So then you have your net
income during the period.

00:01:09.386 --> 00:01:11.260
And here we'll literally
just take whatever's

00:01:11.260 --> 00:01:13.350
reported from the
income statement.

00:01:13.350 --> 00:01:17.032
So over there, we
get $200 net income.

00:01:17.032 --> 00:01:18.990
And now, we have to do
the reconciliation part.

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Because if this was all
cash that you were getting,

00:01:21.310 --> 00:01:24.730
then you should have $300 in
cash at the end of the period,

00:01:24.730 --> 00:01:26.210
which we clearly don't have.

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So we have to
reconcile by looking

00:01:27.770 --> 00:01:30.640
at the changes in different
things on the balance sheets.

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Over here, we have a net
change in accounts receivable.

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So we have an increase
in accounts receivable.

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So I'll call it AR Increase,
AR short for accounts

00:01:42.130 --> 00:01:44.042
receivable just to
save some space.

00:01:44.042 --> 00:01:45.250
So let's just think about it.

00:01:45.250 --> 00:01:48.080
When you have an increase
in accounts receivable,

00:01:48.080 --> 00:01:50.340
you're letting
people owe you money.

00:01:50.340 --> 00:01:52.920
You're letting
people owe you $400.

00:01:52.920 --> 00:01:55.960
If you didn't let them owe
you, that would have been cash.

00:01:55.960 --> 00:01:57.669
So you're kind of
pushing back the time

00:01:57.669 --> 00:01:58.710
that you're getting cash.

00:01:58.710 --> 00:02:02.450
This is $400 that you
didn't get that maybe you

00:02:02.450 --> 00:02:05.790
could have gotten if you
didn't allow this person

00:02:05.790 --> 00:02:07.860
to delay when they paid you.

00:02:07.860 --> 00:02:10.479
So an increase in
accounts receivables

00:02:10.479 --> 00:02:13.780
is actually less cash than you
would have otherwise gotten.

00:02:13.780 --> 00:02:18.620
So this is negative
$400 for your cash flow.

00:02:18.620 --> 00:02:19.809
And we had no other changes.

00:02:19.809 --> 00:02:21.600
I don't even address
accounts payable here.

00:02:21.600 --> 00:02:25.400
That's essentially
pushing back owing people,

00:02:25.400 --> 00:02:27.490
paying other people,
paying your vendors money.

00:02:27.490 --> 00:02:30.040
But I don't even address
that in the previous example.

00:02:30.040 --> 00:02:32.260
No other changes
in our liabilities.

00:02:32.260 --> 00:02:34.530
So this is the only
adjustment we make.

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And so if we do this--
and sometimes this

00:02:36.950 --> 00:02:40.940
will be called a use of
cash or a subtraction from

00:02:40.940 --> 00:02:43.730
or there's different
ways it can be phrased

00:02:43.730 --> 00:02:45.690
in different contexts--
but over here,

00:02:45.690 --> 00:02:48.260
you'll have your net
cash from operations,

00:02:48.260 --> 00:02:52.390
cash from operations.

00:02:52.390 --> 00:02:53.530
I'll just say ops.

00:02:53.530 --> 00:02:57.230
And over here, you can
see, when you add it all,

00:02:57.230 --> 00:02:59.930
just the cash from
operations, $200 minus $400.

00:02:59.930 --> 00:03:02.130
So I'm just adding this
part right over here.

00:03:02.130 --> 00:03:04.560
You have negative $200.

00:03:04.560 --> 00:03:06.440
And so your starting
cash is $100.

00:03:06.440 --> 00:03:08.509
You have negative $200
cash from operations.

00:03:08.509 --> 00:03:10.300
And this is what you
would have also gotten

00:03:10.300 --> 00:03:12.300
if you had done cash accounting.

00:03:12.300 --> 00:03:15.160
You would have had negative
$200 cash from operations.

00:03:15.160 --> 00:03:18.890
And then if you start with
$100, you use $200 in cash,

00:03:18.890 --> 00:03:25.754
your ending cash will
be negative $100.

00:03:25.754 --> 00:03:27.670
So this little thing
that I just created here,

00:03:27.670 --> 00:03:30.970
this little reconciliation
between the positive $200

00:03:30.970 --> 00:03:33.780
in income and the
negative $200 of cash,

00:03:33.780 --> 00:03:36.610
and showing how we got from
this starting point in cash

00:03:36.610 --> 00:03:39.720
to this ending point, this
is a cash flow statement.

00:03:39.720 --> 00:03:43.570
So you now know the three
major financial statements.


Balance sheet and income statement relationship

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Language: en

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Let's see if we
can use our example

00:00:01.920 --> 00:00:05.130
to understand the three
types of income statements,

00:00:05.130 --> 00:00:07.440
and hopefully understanding
those income statements

00:00:07.440 --> 00:00:10.115
will also help us
understand this example.

00:00:10.115 --> 00:00:11.490
So I'm going to
start off-- we're

00:00:11.490 --> 00:00:12.640
going to focus on month two.

00:00:12.640 --> 00:00:14.014
And what I have
done is I've just

00:00:14.014 --> 00:00:17.100
rewritten some of this accrual
income statement down here.

00:00:17.100 --> 00:00:18.800
So it really looks
like a statement.

00:00:18.800 --> 00:00:20.990
So this right here is
the income statement

00:00:20.990 --> 00:00:24.660
for month two on
an accrual basis.

00:00:24.660 --> 00:00:27.550
In that month, we
said we had $400

00:00:27.550 --> 00:00:30.260
of revenue, $200 of expense.

00:00:30.260 --> 00:00:34.990
400 minus 200 gives
us $200 of income.

00:00:34.990 --> 00:00:36.950
An income statement
tells us what

00:00:36.950 --> 00:00:38.861
happened over a period of time.

00:00:38.861 --> 00:00:41.360
What was the activity-- how
much revenue, how much expenses,

00:00:41.360 --> 00:00:42.240
and other things.

00:00:42.240 --> 00:00:43.920
This is just a
super simplified one

00:00:43.920 --> 00:00:47.730
without taxes, without interest,
without other types of expenses

00:00:47.730 --> 00:00:49.020
over here.

00:00:49.020 --> 00:00:52.744
I also have drawn the balance
sheet at the end of month one

00:00:52.744 --> 00:00:54.660
and the balance sheet
at the end of month two.

00:00:54.660 --> 00:00:56.200
Or you could also view
this balance sheet here

00:00:56.200 --> 00:00:58.440
as the balance sheet at
the beginning of month two.

00:00:58.440 --> 00:01:02.100
And the main thing to realize
is income statement tells you

00:01:02.100 --> 00:01:06.320
what happens over a time
period, while balance sheets are

00:01:06.320 --> 00:01:11.980
snapshots, or they're pictures
at a given moment-- snapshots.

00:01:11.980 --> 00:01:14.210
So this tells us
essentially what did I have.

00:01:14.210 --> 00:01:17.490
The assets are the things that
can give me future benefit,

00:01:17.490 --> 00:01:18.590
so what do I have.

00:01:18.590 --> 00:01:20.650
And the liabilities
are things that I

00:01:20.650 --> 00:01:23.460
have to give future benefit
to, or things that I owe.

00:01:23.460 --> 00:01:24.710
So this is what I have.

00:01:24.710 --> 00:01:26.040
This is what I owe.

00:01:26.040 --> 00:01:28.500
And then the equity is what
I really have to my name

00:01:28.500 --> 00:01:32.190
if I net out the
liabilities from the assets.

00:01:32.190 --> 00:01:34.100
So at the beginning
of month two--

00:01:34.100 --> 00:01:35.520
which is the end
of month one-- I

00:01:35.520 --> 00:01:39.200
had $100 of cash, no
accounts receivables.

00:01:39.200 --> 00:01:40.670
I didn't owe anyone anything.

00:01:40.670 --> 00:01:41.670
I didn't owe them money.

00:01:41.670 --> 00:01:43.390
I didn't owe them services.

00:01:43.390 --> 00:01:47.370
So 100 minus 0 means I had $100.

00:01:47.370 --> 00:01:49.760
That's kind of what the
owners of the company

00:01:49.760 --> 00:01:52.980
can say they have of value at
the beginning of the month.

00:01:52.980 --> 00:01:56.750
You fast forward-- now
at the end of month two--

00:01:56.750 --> 00:01:58.720
I now owe the bank $100.

00:01:58.720 --> 00:02:00.946
So I just put this as
negative $100 here.

00:02:00.946 --> 00:02:02.320
It normally wouldn't
be accounted

00:02:02.320 --> 00:02:05.180
that way on an actual
company's balance sheet,

00:02:05.180 --> 00:02:07.150
but this is simplified.

00:02:07.150 --> 00:02:10.180
But I have an accounts
receivable of $400.

00:02:10.180 --> 00:02:13.744
So my total assets now
are $300 of assets.

00:02:13.744 --> 00:02:15.160
And remember,
accounts receivables

00:02:15.160 --> 00:02:18.110
are an asset because
someone owes me something.

00:02:18.110 --> 00:02:20.630
Someone owes me
cash in the future.

00:02:20.630 --> 00:02:22.610
I still have no liabilities.

00:02:22.610 --> 00:02:26.020
So you take all of your assets,
minus all of your liabilities,

00:02:26.020 --> 00:02:29.500
and now I have $300 in equity.

00:02:29.500 --> 00:02:31.880
So you can see the
snapshot at the beginning

00:02:31.880 --> 00:02:33.690
of the month, 100 in equity.

00:02:33.690 --> 00:02:36.920
Snapshot at the end of
the month, 300 in equity.

00:02:36.920 --> 00:02:39.490
And so to go from one
point to the other,

00:02:39.490 --> 00:02:44.430
to go from 100 to 300, I must
have grown in equity by 200.

00:02:44.430 --> 00:02:48.420
I must have gotten $200 worth
of value from someplace.

00:02:48.420 --> 00:02:50.770
And that's what the income
statement describes.

00:02:50.770 --> 00:02:52.390
It describes it right over here.

00:02:52.390 --> 00:02:54.380
The change in equity,
sometimes it's

00:02:54.380 --> 00:03:00.290
the change in returned earnings
or just change in equity.

00:03:00.290 --> 00:03:04.230
That is going to be
the $200 in net income

00:03:04.230 --> 00:03:06.409
that the company got
over that time period.

00:03:06.409 --> 00:03:08.200
Now, there's one thing
that you're probably

00:03:08.200 --> 00:03:09.620
confused by right now.

00:03:09.620 --> 00:03:11.990
It's like, well, how do
we reconcile everything

00:03:11.990 --> 00:03:12.630
with the cash?

00:03:12.630 --> 00:03:15.660
We know that over this
period we got $200 in income

00:03:15.660 --> 00:03:16.785
on an accrual basis.

00:03:16.785 --> 00:03:18.160
But when you look
at the cash, we

00:03:18.160 --> 00:03:22.250
went from $100 positive cash,
to negative $100 in cash.

00:03:22.250 --> 00:03:24.500
It looks like we lost $200.

00:03:24.500 --> 00:03:28.390
So how can we reconcile the
fact that we got $200 in income?

00:03:28.390 --> 00:03:30.540
How can we reconcile
that with the fact

00:03:30.540 --> 00:03:33.960
that we lost $200 in cash?

00:03:33.960 --> 00:03:35.940
And that reconciliation
is going to be

00:03:35.940 --> 00:03:37.550
done on the cash flow statement.

00:03:37.550 --> 00:03:40.320
And I'll do that
in the next video.


Comparing accrual and cash accounting

WEBVTT
Kind: captions
Language: en

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So one of the main purposes
of accounting for anything,

00:00:03.860 --> 00:00:06.920
of making these accounting
statements in the first place,

00:00:06.920 --> 00:00:08.490
is so that you
can reflect what's

00:00:08.490 --> 00:00:09.740
going on in the business.

00:00:09.740 --> 00:00:13.550
And that might be for investors,
to see how business is doing,

00:00:13.550 --> 00:00:15.640
or it might be for the
managers of a business,

00:00:15.640 --> 00:00:18.627
so that they can see where
the business is doing well,

00:00:18.627 --> 00:00:20.210
or where it's not
doing well, or maybe

00:00:20.210 --> 00:00:22.150
how resources
should be allocated.

00:00:22.150 --> 00:00:24.990
So let's see which of these two
methods of accounting, the cash

00:00:24.990 --> 00:00:28.140
method or the accrual method,
give a better indication

00:00:28.140 --> 00:00:30.180
of what's actually going
on in the business.

00:00:30.180 --> 00:00:32.180
And the way I did it in
the first two videos,

00:00:32.180 --> 00:00:34.510
for each month, this first
column right over here,

00:00:34.510 --> 00:00:37.980
this is the cash
basis of accounting.

00:00:37.980 --> 00:00:40.060
And this right here
is the accrual.

00:00:40.060 --> 00:00:42.054
So the second column
is the accrual.

00:00:42.054 --> 00:00:43.720
Let's just look at
the income statement.

00:00:43.720 --> 00:00:47.970
We're assuming a very simple
world where there's no taxes.

00:00:47.970 --> 00:00:49.310
We have no debt.

00:00:49.310 --> 00:00:51.000
We have no interest,
things like that.

00:00:51.000 --> 00:00:53.810
We just literally have revenue,
some expenses associated

00:00:53.810 --> 00:00:55.705
with that revenue, and
just a simple profit.

00:00:55.705 --> 00:00:57.580
We'll make it more
complicated in the future.

00:00:57.580 --> 00:01:00.170
So this right here, you could
view as our income statement.

00:01:00.170 --> 00:01:03.670
This is our income statement
for month one on a cash basis.

00:01:03.670 --> 00:01:07.939
This is our income statement on
month one on an accrual basis.

00:01:07.939 --> 00:01:09.980
Now when you look at the
cash basis in month one,

00:01:09.980 --> 00:01:13.184
and when you look at
either basis on month one,

00:01:13.184 --> 00:01:14.350
it gives you the same thing.

00:01:14.350 --> 00:01:15.558
So that's not so interesting.

00:01:15.558 --> 00:01:17.230
Let's go to month two.

00:01:17.230 --> 00:01:19.410
In the cash basis
of accounting, it

00:01:19.410 --> 00:01:22.169
looks like you just lost $200.

00:01:22.169 --> 00:01:24.710
To an outsider who didn't know
the details of what's actually

00:01:24.710 --> 00:01:26.210
going on in the
business, they think

00:01:26.210 --> 00:01:28.990
something shady is going on, or
it's a money losing business.

00:01:28.990 --> 00:01:30.448
Why would I want
to invest in this?

00:01:30.448 --> 00:01:32.940
They're losing $200 a month,
just looking at this month

00:01:32.940 --> 00:01:33.455
alone.

00:01:33.455 --> 00:01:35.080
But when you look at
the accrual basis,

00:01:35.080 --> 00:01:37.840
it better reflects that look,
you actually did some catering.

00:01:37.840 --> 00:01:40.720
In fact, you did a pretty large
catering event that month.

00:01:40.720 --> 00:01:43.710
In fact, that's why you
had so many expenses.

00:01:43.710 --> 00:01:46.670
And if you recognize the
revenue for the service

00:01:46.670 --> 00:01:48.240
that you actually
did that month,

00:01:48.240 --> 00:01:51.064
that $400, which we did
in the accrual basis,

00:01:51.064 --> 00:01:52.480
then you could
actually say, look,

00:01:52.480 --> 00:01:56.030
I performed services
that will earn me $200,

00:01:56.030 --> 00:01:57.720
assuming that the
customer is going

00:01:57.720 --> 00:01:59.230
to be good for their money.

00:01:59.230 --> 00:02:02.480
And instead of putting that
$400 in cash, because you didn't

00:02:02.480 --> 00:02:04.160
get the cash, you can't do that.

00:02:04.160 --> 00:02:07.660
We said, look, the
customer owes us $400.

00:02:07.660 --> 00:02:08.940
But that's still an asset.

00:02:08.940 --> 00:02:11.150
An asset is anything
that someone owes you,

00:02:11.150 --> 00:02:12.390
some future benefit.

00:02:12.390 --> 00:02:15.700
So the customer is going to
give you cash in the future.

00:02:15.700 --> 00:02:18.734
Cash is an asset because you
can use that to go buy stuff,

00:02:18.734 --> 00:02:20.400
to get other people
to do stuff for you,

00:02:20.400 --> 00:02:21.880
to get some future benefit.

00:02:21.880 --> 00:02:25.240
So both cash and accounts
receivables are assets.

00:02:25.240 --> 00:02:26.940
And so in month two,
I think it's fair

00:02:26.940 --> 00:02:29.880
that accrual method is giving
us a better indication of what

00:02:29.880 --> 00:02:30.950
actually happened.

00:02:30.950 --> 00:02:32.600
Let's go to month three.

00:02:32.600 --> 00:02:34.744
On the cash basis, when
you look at the example,

00:02:34.744 --> 00:02:36.410
you actually did
nothing in month three.

00:02:36.410 --> 00:02:38.451
You could have gone on a
vacation in month three.

00:02:38.451 --> 00:02:39.910
There was no actual
catering done.

00:02:39.910 --> 00:02:41.734
But on the cash basis,
it looks like this

00:02:41.734 --> 00:02:44.150
was your best month of catering
ever, because you actually

00:02:44.150 --> 00:02:46.755
get $600 inflow in
cash, and you didn't

00:02:46.755 --> 00:02:48.380
have to spend any
expenses, because you

00:02:48.380 --> 00:02:49.690
didn't do any accounting.

00:02:49.690 --> 00:02:51.140
But when you do
the accrual basis,

00:02:51.140 --> 00:02:52.640
it actually reflected
what happened.

00:02:52.640 --> 00:02:55.040
You had no revenue
and no expenses

00:02:55.040 --> 00:02:56.690
associated with that revenue.

00:02:56.690 --> 00:02:58.440
So once again, to an
outsider, they'd say,

00:02:58.440 --> 00:03:00.699
hey month three, maybe
you took a break,

00:03:00.699 --> 00:03:02.490
maybe you took a
vacation, or that was just

00:03:02.490 --> 00:03:05.070
a slow time in your business.

00:03:05.070 --> 00:03:07.270
And you don't
recognize the revenue

00:03:07.270 --> 00:03:10.460
from this $200 in advance,
because you didn't do anything

00:03:10.460 --> 00:03:10.960
to get it.

00:03:10.960 --> 00:03:15.650
Instead, you said, look, I got
this $200, it's a cash advance,

00:03:15.650 --> 00:03:18.430
you could've even called this
a cash advance from customers,

00:03:18.430 --> 00:03:20.910
but I'm not recognizing
this in revenue in the month

00:03:20.910 --> 00:03:21.550
that I got it.

00:03:21.550 --> 00:03:25.080
I'm waiting until I actually
perform the service.

00:03:25.080 --> 00:03:27.220
So I'm deferring the revenue.

00:03:27.220 --> 00:03:29.530
And so you defer it to
month four when you actually

00:03:29.530 --> 00:03:31.240
perform the service.

00:03:31.240 --> 00:03:34.910
The $100 in expenses are
associated with that $200.

00:03:34.910 --> 00:03:37.360
And so it makes sense to
you had $100 in profit.

00:03:37.360 --> 00:03:39.620
Once again, in month
four, you did work,

00:03:39.620 --> 00:03:40.970
you should have profit.

00:03:40.970 --> 00:03:44.580
On a cash basis, it looks
like you lost money again.

00:03:44.580 --> 00:03:46.550
So hopefully this
gives you a little bit

00:03:46.550 --> 00:03:49.330
of an idea of why accrual gives
a better picture of what's

00:03:49.330 --> 00:03:50.650
happening in the business.

00:03:50.650 --> 00:03:55.610
In the next video, I'll try
to reconcile what the accrual

00:03:55.610 --> 00:03:58.200
income statement is telling
us and the actual cash,

00:03:58.200 --> 00:04:01.020
because right now it might
look a little mysterious.


Accrual basis of accounting

WEBVTT
Kind: captions
Language: en

00:00:00.610 --> 00:00:03.120
Let's now account for the
same series of events,

00:00:03.120 --> 00:00:04.930
but instead of doing
it on a cash basis,

00:00:04.930 --> 00:00:06.790
let's do it on an accrual basis.

00:00:06.790 --> 00:00:08.800
And the whole idea
with accrual accounting

00:00:08.800 --> 00:00:11.650
is to match your revenues and
expenses to when you actually

00:00:11.650 --> 00:00:13.070
perform the service.

00:00:13.070 --> 00:00:15.980
So it actually captures
business activity, as opposed

00:00:15.980 --> 00:00:20.080
to just capturing when
cash changes hands.

00:00:20.080 --> 00:00:21.930
So let's see what
that actually means.

00:00:21.930 --> 00:00:24.320
So in month one, you cater an
event where the cost to you

00:00:24.320 --> 00:00:25.560
was $100.

00:00:25.560 --> 00:00:28.390
The customer pays you
$200 for your services.

00:00:28.390 --> 00:00:30.890
And what I'll do, I'll do the
accrual accounting right here.

00:00:30.890 --> 00:00:32.990
So this is kind of the
cash income statement.

00:00:32.990 --> 00:00:36.300
Let's do the accrual
accounting income statement.

00:00:36.300 --> 00:00:39.830
So you actually provided
the service of catering,

00:00:39.830 --> 00:00:42.170
you got $200 for your services.

00:00:42.170 --> 00:00:44.960
So I'll put $200 in for revenue.

00:00:44.960 --> 00:00:47.530
And the expenses associated
with that service

00:00:47.530 --> 00:00:52.720
that you provided in
month one is $100.

00:00:52.720 --> 00:00:55.810
And so your profit is $100.

00:00:55.810 --> 00:00:59.650
So at least for month one, the
cash basis and accrual basis

00:00:59.650 --> 00:01:01.740
of accounting look
exactly the same.

00:01:01.740 --> 00:01:06.010
And once again, you
have $100 in cash.

00:01:06.010 --> 00:01:07.580
Now let's go to month two.

00:01:07.580 --> 00:01:10.890
You cater an event where
the cost to you was $200.

00:01:10.890 --> 00:01:12.690
You and the customer
agree that they

00:01:12.690 --> 00:01:15.010
can pay you $400 the next month.

00:01:15.010 --> 00:01:17.070
So now it gets
interesting, because you

00:01:17.070 --> 00:01:18.754
performed the
catering that month.

00:01:18.754 --> 00:01:20.670
And the catering that
you performed that month

00:01:20.670 --> 00:01:22.950
is worth $400.

00:01:22.950 --> 00:01:25.050
So in the accrual
basis of accounting,

00:01:25.050 --> 00:01:32.670
would say that you
earned $400 of revenue,

00:01:32.670 --> 00:01:35.225
even though the customer
did not pay you.

00:01:35.225 --> 00:01:36.950
They did not give you the cash.

00:01:36.950 --> 00:01:38.680
And the way that you
account for that,

00:01:38.680 --> 00:01:41.950
is on your balance sheet you
say that you are essentially

00:01:41.950 --> 00:01:43.510
owed $400.

00:01:43.510 --> 00:01:46.420
So this accounts receivable,
this is essentially stuff

00:01:46.420 --> 00:01:48.240
that other people owe you.

00:01:48.240 --> 00:01:50.050
You need to receive
this from other people.

00:01:50.050 --> 00:01:50.800
But it's an asset.

00:01:50.800 --> 00:01:53.330
Other people have an
obligation to you.

00:01:53.330 --> 00:01:56.850
So you have an accounts
receivable of $400.

00:01:56.850 --> 00:01:59.010
When they pay you
the $400, it goes

00:01:59.010 --> 00:02:02.070
from accounts
receivable to cash.

00:02:02.070 --> 00:02:09.280
And then the cost
to you was $200.

00:02:09.280 --> 00:02:12.270
So here, all of a sudden,
you performed the service,

00:02:12.270 --> 00:02:15.690
the revenues and expenses for
that service are in that month.

00:02:15.690 --> 00:02:19.010
And now your profit
here shows $200.

00:02:19.010 --> 00:02:20.740
So it is actually
a better reflection

00:02:20.740 --> 00:02:22.850
of what you did it that month.

00:02:22.850 --> 00:02:26.240
Now, the reality is that you
didn't get the cash for it,

00:02:26.240 --> 00:02:29.440
and you had to spend $200
of cash out of your pocket.

00:02:29.440 --> 00:02:31.420
So you're still, just
like the cash accounting,

00:02:31.420 --> 00:02:40.020
you're still going to have
negative $100 in cash.

00:02:40.020 --> 00:02:42.220
Now, let's go to month three.

00:02:42.220 --> 00:02:45.510
You get $400 from the
customer the previous month.

00:02:45.510 --> 00:02:47.540
Now with cash basis, you
would have added that

00:02:47.540 --> 00:02:48.206
to your revenue.

00:02:48.206 --> 00:02:50.235
But here we already
accounted for it

00:02:50.235 --> 00:02:51.360
in the accounts receivable.

00:02:51.360 --> 00:02:53.760
We already took that
revenue, but because you

00:02:53.760 --> 00:02:56.270
got the $400 in cash, it's
going to just disappear

00:02:56.270 --> 00:02:59.570
from receivables and then go
into cash, because you actually

00:02:59.570 --> 00:03:00.330
got it.

00:03:00.330 --> 00:03:03.250
You get $400 from the
customer the previous month.

00:03:03.250 --> 00:03:05.715
You also get $200 in
advance from a customer

00:03:05.715 --> 00:03:08.050
that you have to cater
for the next month.

00:03:08.050 --> 00:03:10.080
So you did no catering
in month three,

00:03:10.080 --> 00:03:12.590
and because you did no
catering in month three,

00:03:12.590 --> 00:03:15.180
you have zero revenue
in month three.

00:03:15.180 --> 00:03:17.780
And then you also
have zero expenses.

00:03:17.780 --> 00:03:21.040
The way that you account
for the $400 that you got,

00:03:21.040 --> 00:03:24.560
is that your accounts
receivables goes to 0.

00:03:24.560 --> 00:03:26.690
And that goes to cash.

00:03:26.690 --> 00:03:30.550
So the negative $100,
you add $400 to it,

00:03:30.550 --> 00:03:32.880
so it will become positive $300.

00:03:32.880 --> 00:03:36.940
And the way that you account
for this $200 in advance

00:03:36.940 --> 00:03:40.210
from a customer, is you
call that deferred revenue.

00:03:40.210 --> 00:03:41.670
You've got the cash there.

00:03:41.670 --> 00:03:46.604
So we went from negative
$100, added $400 to $300.

00:03:46.604 --> 00:03:48.520
You get another $200 in
cash, so that gives us

00:03:48.520 --> 00:03:51.480
$500 in cash again.

00:03:51.480 --> 00:03:53.160
But we didn't earn any revenue.

00:03:53.160 --> 00:03:56.750
That $200, that was a
kind of a cash advance.

00:03:56.750 --> 00:03:59.470
So we put that right over
here in deferred revenue.

00:03:59.470 --> 00:04:03.300
That's revenue that we're
deferring to a future period.

00:04:03.300 --> 00:04:05.240
In the future, we will earn it.

00:04:05.240 --> 00:04:06.790
This is now a
liability, because we

00:04:06.790 --> 00:04:09.170
are obligated to
earn that revenue.

00:04:09.170 --> 00:04:11.990
And then in month four, we
actually earn the revenue.

00:04:11.990 --> 00:04:14.090
So in month four,
we can actually

00:04:14.090 --> 00:04:17.940
put it on our income
statement at $200.

00:04:17.940 --> 00:04:21.290
And then we had
$100 of expenses.

00:04:21.290 --> 00:04:24.700
So we have this $100
right over here.

00:04:24.700 --> 00:04:29.420
And so in month
four, we earned $100.

00:04:29.420 --> 00:04:34.350
And once again, $100 went
away from our cash balance.

00:04:34.350 --> 00:04:36.860
So we still have $400.

00:04:36.860 --> 00:04:39.390
So whether you do the cash
basis or the accrual basis,

00:04:39.390 --> 00:04:41.780
you have the same
exact amount of cash.

00:04:41.780 --> 00:04:45.320
But what's more interesting
is how the profit

00:04:45.320 --> 00:04:46.716
relates in each of the periods.

00:04:46.716 --> 00:04:48.840
And I'll talk about that
in a little bit more depth

00:04:48.840 --> 00:04:50.810
in the next video.


Cash accounting

WEBVTT
Kind: captions
Language: en

00:00:00.610 --> 00:00:03.030
To see the difference between
cash accounting and accrual

00:00:03.030 --> 00:00:04.820
accounting, I'm going to go
through this little example.

00:00:04.820 --> 00:00:06.528
And first I'm going
to account for things

00:00:06.528 --> 00:00:09.040
using a cash basis
of accounting.

00:00:09.040 --> 00:00:11.064
And then we'll do it
with an accrual basis.

00:00:11.064 --> 00:00:12.480
And just so you
have some context,

00:00:12.480 --> 00:00:16.300
the cash basis is any time
you get cash from a customer,

00:00:16.300 --> 00:00:17.720
you would count that as revenue.

00:00:17.720 --> 00:00:19.530
And any time you
have to spend cash,

00:00:19.530 --> 00:00:21.130
you count that as an expense.

00:00:21.130 --> 00:00:24.320
And you'll see that that's
what most small businesses do,

00:00:24.320 --> 00:00:27.340
while most slightly more
sophisticated businesses would

00:00:27.340 --> 00:00:32.590
use accrual-based accounting,
because that matches up

00:00:32.590 --> 00:00:35.750
your actual expenses and your
revenue a little bit better

00:00:35.750 --> 00:00:36.630
in each period.

00:00:36.630 --> 00:00:38.213
So let's just go
through this example,

00:00:38.213 --> 00:00:40.150
using the cash basis first.

00:00:40.150 --> 00:00:42.770
And we're going to assume that
we start off with no money.

00:00:42.770 --> 00:00:46.500
So in Month 1, you cater an
event where the cost to you

00:00:46.500 --> 00:00:48.230
was $100.

00:00:48.230 --> 00:00:51.130
The customer pays you
$200 for your services.

00:00:51.130 --> 00:00:53.510
And maybe they pay your
$200 ahead of time,

00:00:53.510 --> 00:00:57.100
so that you have the cash to go
buy the food and the paper cups

00:00:57.100 --> 00:00:58.410
and paper plates or whatever.

00:00:58.410 --> 00:01:00.270
So you get $200 in revenue.

00:01:00.270 --> 00:01:02.300
This is a cash
basis of accounting.

00:01:02.300 --> 00:01:06.490
And you get to spend
$100 of that on supplies,

00:01:06.490 --> 00:01:08.790
and maybe you had
to hire some help,

00:01:08.790 --> 00:01:10.450
and you had to pay
yourself a salary.

00:01:10.450 --> 00:01:13.400
So if you got $200, and
you used $100 of that,

00:01:13.400 --> 00:01:17.880
your profit here-- I'll
do profit in green --

00:01:17.880 --> 00:01:21.670
your profit is going to
be-- no, that's not green--

00:01:21.670 --> 00:01:25.490
your profit is going to be $100.

00:01:25.490 --> 00:01:27.320
And if you started
with no cash, your cash

00:01:27.320 --> 00:01:28.820
at the end of
period-- this is going

00:01:28.820 --> 00:01:30.500
to be the cash at
the end of Month 1--

00:01:30.500 --> 00:01:33.890
you will now have $100 of cash.

00:01:33.890 --> 00:01:35.230
Now let's go to Month 2.

00:01:35.230 --> 00:01:41.000
You cater an event where
the cost to you was $200.

00:01:41.000 --> 00:01:42.840
You and the customer
agree that they

00:01:42.840 --> 00:01:46.450
can pay you $400 the next month.

00:01:46.450 --> 00:01:50.210
So in this month,
we have to use $200,

00:01:50.210 --> 00:01:52.390
maybe our bank
lets us overdraft,

00:01:52.390 --> 00:01:55.904
so let's say-- I shouldn't
write-- This is an expense,

00:01:55.904 --> 00:01:57.320
so I don't have
to write negative,

00:01:57.320 --> 00:02:00.240
we're assuming this is going
out, I'll write it in red.

00:02:00.240 --> 00:02:04.810
So we are going to use $200,
but we don't get any revenue

00:02:04.810 --> 00:02:06.830
because we're doing the
cash basis accounting.

00:02:06.830 --> 00:02:08.660
The customer's not
paying us in that month.

00:02:08.660 --> 00:02:10.720
They're paying us
$400 the next month.

00:02:10.720 --> 00:02:12.702
So we get no revenue
in that period.

00:02:12.702 --> 00:02:14.160
So it looks like
we got no revenue.

00:02:14.160 --> 00:02:15.870
We had $200 of expenses.

00:02:15.870 --> 00:02:20.745
Our profit here is going
to be negative $200.

00:02:20.745 --> 00:02:22.860
And when we look
at how much cash,

00:02:22.860 --> 00:02:25.830
we had $100 of cash
entering into Month 2.

00:02:25.830 --> 00:02:28.060
We're using $200 of that.

00:02:28.060 --> 00:02:30.840
And so now we've kind of
overdrawn our bank balance.

00:02:30.840 --> 00:02:34.000
Maybe we owe our bank now $100.

00:02:34.000 --> 00:02:36.570
Let's go to Month 2.

00:02:36.570 --> 00:02:40.240
You get $400 from the customer
in the previous month.

00:02:40.240 --> 00:02:43.135
You also get $200 in
advance from a customer

00:02:43.135 --> 00:02:45.920
that you have to
cater for next month.

00:02:45.920 --> 00:02:47.582
So we've done no
catering this month,

00:02:47.582 --> 00:02:48.790
but we've got a lot of money.

00:02:48.790 --> 00:02:51.200
We got $400 from the
previous month's customer

00:02:51.200 --> 00:02:53.780
and $200 for a
customer that you're

00:02:53.780 --> 00:02:55.230
going to cater for next month.

00:02:55.230 --> 00:03:00.120
So we got $600 on the
cash basis in revenue.

00:03:00.120 --> 00:03:01.780
And we had no expenses
in that month.

00:03:01.780 --> 00:03:06.380
So we have $600 in profit,
and our cash balance increases

00:03:06.380 --> 00:03:06.955
by $600.

00:03:06.955 --> 00:03:11.680
So at the end of this
month, we now have $500.

00:03:11.680 --> 00:03:14.360
Now Month 4, you cater
the last customer's event.

00:03:14.360 --> 00:03:16.580
It cost you $100.

00:03:16.580 --> 00:03:19.690
So once again, you
just have to spend--

00:03:19.690 --> 00:03:21.910
I want to do that in
magenta-- you just

00:03:21.910 --> 00:03:27.540
have to spend the $100 in Month
4 to cater the actual event,

00:03:27.540 --> 00:03:29.400
but you got no
revenue in that month.

00:03:29.400 --> 00:03:32.920
So it looks like you took
a loss, negative $100.

00:03:32.920 --> 00:03:40.810
And then your cash balance
will go down to $400.

00:03:40.810 --> 00:03:42.100
So this is a cash basis.

00:03:42.100 --> 00:03:43.780
This is how a lot of
businesses run it.

00:03:43.780 --> 00:03:45.571
But as you can see,
there's a problem here.

00:03:45.571 --> 00:03:49.360
It looks like our profit is
jumping all over the place.

00:03:49.360 --> 00:03:51.360
Sometimes we're profitable,
sometimes we're not.

00:03:51.360 --> 00:03:53.450
Sometimes we're profitable,
sometimes we're not.

00:03:53.450 --> 00:03:56.290
Even though our business is a
little bit steadier than that

00:03:56.290 --> 00:03:59.010
would seem to imply.


Upper bound on forward settlement price

WEBVTT
Kind: captions
Language: en

00:00:00.600 --> 00:00:03.850
Let's see if there's a way
to make a risk free profit.

00:00:03.850 --> 00:00:06.300
And let me just tell you
right from the get go,

00:00:06.300 --> 00:00:08.039
there's usually not
many ways to make

00:00:08.039 --> 00:00:09.500
a risk free profit in the world.

00:00:09.500 --> 00:00:11.110
So this is very theoretical.

00:00:11.110 --> 00:00:14.232
If the spot price for
gold was $1,000-- so

00:00:14.232 --> 00:00:16.440
the spot price literally
just means the market price.

00:00:16.440 --> 00:00:19.460
If you were to buy or sell gold
today and actually exchange

00:00:19.460 --> 00:00:22.270
hands, then you
would pay or sell

00:00:22.270 --> 00:00:24.690
the gold for $1,000 per ounce.

00:00:24.690 --> 00:00:27.480
And let's also say that the
one year forward settlement

00:00:27.480 --> 00:00:30.230
price is $1,200 per ounce.

00:00:30.230 --> 00:00:33.770
So if you want to buy
gold one year from now,

00:00:33.770 --> 00:00:36.110
you could agree right
now to buy it for $1,200.

00:00:36.110 --> 00:00:38.170
Or if you want to sell
gold one year from now,

00:00:38.170 --> 00:00:41.280
you could agree right
now to sell it for $1,200

00:00:41.280 --> 00:00:44.410
by entering into a forward,
or futures, contract.

00:00:44.410 --> 00:00:47.240
And just the other details, the
interest rate to borrow money

00:00:47.240 --> 00:00:52.960
is 10%, and the carrying cost of
gold is $50 per ounce per year.

00:00:52.960 --> 00:00:55.960
And the carrying cost means,
if I had an ounce of gold,

00:00:55.960 --> 00:00:57.730
and I wanted to hold
it responsibly-- I

00:00:57.730 --> 00:01:00.820
wanted to store it, maybe
someplace in a safe at a bank,

00:01:00.820 --> 00:01:03.040
and I wanted to insure
it in case it got stolen,

00:01:03.040 --> 00:01:05.430
or in case someone lost
it-- that would cost me

00:01:05.430 --> 00:01:07.690
$50 per ounce per year.

00:01:07.690 --> 00:01:09.660
So that's what we
mean by carrying cost.

00:01:09.660 --> 00:01:11.410
Let's say you could
also invest money risk

00:01:11.410 --> 00:01:13.451
free in this type of a
market-- I've just made up

00:01:13.451 --> 00:01:15.690
these numbers-- for 5% a year.

00:01:15.690 --> 00:01:18.530
So, how could you
make the money?

00:01:18.530 --> 00:01:20.460
We're assuming you
start with nothing.

00:01:20.460 --> 00:01:29.780
So you could literally
just borrow $1,000,

00:01:29.780 --> 00:01:32.000
and then you use that
to buy an ounce of gold

00:01:32.000 --> 00:01:42.255
in the spot market, and you also
agree to sell it in the future.

00:01:46.250 --> 00:01:47.990
So you enter into
that forward contract.

00:01:47.990 --> 00:01:56.015
Let me write this way-- enter
into forward as the seller.

00:01:58.700 --> 00:02:01.560
So, on the spot market
you are the buyer,

00:02:01.560 --> 00:02:03.900
and on the forward
market, one year from now,

00:02:03.900 --> 00:02:06.330
you agree to be the seller.

00:02:06.330 --> 00:02:10.320
So, let's just think about
how this is going to play out.

00:02:10.320 --> 00:02:13.570
So over the course of the
year, you will have some costs.

00:02:13.570 --> 00:02:16.760
You will have to pay the
interest on this $1,000.

00:02:16.760 --> 00:02:17.920
That's 10%.

00:02:17.920 --> 00:02:21.970
So you're going to
pay $100 in interest.

00:02:21.970 --> 00:02:25.190
And you're going to pay the
carrying cost, $50 per ounce.

00:02:25.190 --> 00:02:28.490
So $50 carrying cost.

00:02:31.140 --> 00:02:35.420
And so, when we end
up a year from now,

00:02:35.420 --> 00:02:46.782
you will sell the gold $1,200.

00:02:46.782 --> 00:02:48.490
And you know you can
do that, because you

00:02:48.490 --> 00:02:50.810
entered into the
forward agreement.

00:02:50.810 --> 00:03:04.070
And then you can pay back the
$1,000 loan plus $100 interest.

00:03:04.070 --> 00:03:05.820
And let's say you have
to pay the carrying

00:03:05.820 --> 00:03:07.620
cost at the end of
the year to the bank.

00:03:07.620 --> 00:03:10.890
So plus the $50 carrying cost.

00:03:10.890 --> 00:03:13.590
So how much did we profit?

00:03:13.590 --> 00:03:18.510
Well, we get $1,200, and
we have to pay back $1,150.

00:03:18.510 --> 00:03:22.350
So $1,200 minus $1,000
minus $100 minus $50,

00:03:22.350 --> 00:03:27.590
we make a profit of $50.

00:03:27.590 --> 00:03:31.200
So the big takeaway here is
that these type of things

00:03:31.200 --> 00:03:32.200
normally don't exist.

00:03:32.200 --> 00:03:34.670
If they did, people would
do it all day and all night.

00:03:34.670 --> 00:03:36.720
And this price would
go up, because everyone

00:03:36.720 --> 00:03:38.520
would want to buy on
spot, and this price

00:03:38.520 --> 00:03:40.220
would go down because
everyone would

00:03:40.220 --> 00:03:42.160
want to sell in
the futures market.

00:03:42.160 --> 00:03:44.300
Everyone would want
to do this right here.

00:03:44.300 --> 00:03:48.100
So the appropriate price
is, this price, based

00:03:48.100 --> 00:03:49.730
on these numbers
right here should not

00:03:49.730 --> 00:03:51.910
be any higher than $1,150.

00:03:51.910 --> 00:03:53.980
So, the correct
market price here,

00:03:53.980 --> 00:03:56.290
if we didn't want
to risk free profit

00:03:56.290 --> 00:03:58.790
or essentially what the
arbitragers would make

00:03:58.790 --> 00:04:02.360
happen by taking
advantage of this,

00:04:02.360 --> 00:04:04.000
it would eventually
go to $1,150.

00:04:04.000 --> 00:04:05.970
So it's essentially
the spot price

00:04:05.970 --> 00:04:08.580
plus the cost to borrow
money at that spot

00:04:08.580 --> 00:04:12.062
price plus the carrying cost.

00:04:12.062 --> 00:04:13.520
So that's essentially
what would be

00:04:13.520 --> 00:04:15.760
the rational price for
the futures contract,

00:04:15.760 --> 00:04:18.340
or the forward settlement price.


Lower bound on forward settlement price

WEBVTT
Kind: captions
Language: en

00:00:00.466 --> 00:00:02.989
In the last video we
established a reasonable

00:00:02.989 --> 00:00:06.204
upper bound on the
1-year forward settlement

00:00:06.204 --> 00:00:08.550
price of gold. We
established that at $1150

00:00:08.550 --> 00:00:11.138
which is essentially
the sport price plus the

00:00:11.138 --> 00:00:15.568
borrowing rate to borrow
$1000, plus the carrying

00:00:15.568 --> 00:00:18.179
cost of the gold. What I
want to do in this video

00:00:18.179 --> 00:00:21.197
is to think of a reasonable
lower bound. To do

00:00:21.197 --> 00:00:23.869
that let's imagine a
world where instead of

00:00:23.869 --> 00:00:26.822
the forward settlement
price being $1150, let's

00:00:26.822 --> 00:00:34.994
imagine a world where the forward
settlement price is $1050.

00:00:34.994 --> 00:00:38.929
It's still higher that the spot
price. Let's think of it from the

00:00:38.929 --> 00:00:41.794
the point of view of
someone who wants to hold

00:00:41.794 --> 00:00:45.602
gold in a year. Let's say
that you are that someone

00:00:45.602 --> 00:00:52.267
and right now you have $1000
that you want to use to

00:00:52.267 --> 00:00:55.863
give you gold. You want
to hold the gold for

00:00:55.863 --> 00:00:57.556
the long term. You have 2 options here.

00:00:57.556 --> 00:01:02.776
You could just buy gold
now. Buy 1 ounce with

00:01:02.776 --> 00:01:07.675
your $1000 right now.
When you go forward a year

00:01:07.675 --> 00:01:12.337
from then your going to
have that 1 once of gold

00:01:12.337 --> 00:01:14.664
plus you're going have
to pay the carrying cost.

00:01:14.664 --> 00:01:17.863
The safety deposit box and
the insurance on the gold.

00:01:17.863 --> 00:01:21.067
You're going to have 1
ounce of gold minus $50.

00:01:21.067 --> 00:01:22.543
That's what you're going have to pay.

00:01:22.543 --> 00:01:24.948
The other option, you say
hey look instead of putting

00:01:24.948 --> 00:01:27.806
my $1000 into gold right
now, let me put my $1000

00:01:27.806 --> 00:01:32.392
into a risk-free bond.
Into a risk-free bond.

00:01:32.392 --> 00:01:39.574
Risk-free bond, and at
the same time agree to

00:01:39.574 --> 00:01:42.664
be the buyer on the
1-year forward settlement.

00:01:42.664 --> 00:01:47.190
On the 1-year forward
contract. I'm agreed to

00:01:47.190 --> 00:01:48.595
to be the buyer at $1050.

00:01:48.595 --> 00:01:51.997
If you go forward a year,
your $1000 risk-free

00:01:51.997 --> 00:01:54.866
bond is going to give
you 5% interest a year.

00:01:54.866 --> 00:02:00.881
You're going to have
$1050. This is just the

00:02:00.881 --> 00:02:04.127
interest on your bond.
Then you can use that

00:02:04.127 --> 00:02:07.683
to go and buy the gold.
Which you all ready locked

00:02:07.683 --> 00:02:11.934
in the price by agreeing
to be the buyer on the

00:02:11.934 --> 00:02:17.779
forward contract. Then you buy the gold.

00:02:17.779 --> 00:02:21.158
In both situations you end
up with an ounce of gold

00:02:21.158 --> 00:02:24.467
a year from now starting with your $1000.

00:02:24.467 --> 00:02:26.529
In this situation you
just have an ounce of gold

00:02:26.529 --> 00:02:28.357
and you didn't have to
pay any carrying cost.

00:02:28.357 --> 00:02:30.633
In this situation you
have the ounce of gold

00:02:30.633 --> 00:02:32.575
and you did have to pay carrying cost.

00:02:32.575 --> 00:02:35.204
So, clearly any rational
person, assuming their

00:02:35.204 --> 00:02:37.983
buying the gold for the
long term, would want to do

00:02:37.983 --> 00:02:41.402
this situation. They
save $50 over the course

00:02:41.402 --> 00:02:46.269
of the year. Really, the
rational price, if this

00:02:46.269 --> 00:02:48.361
were to happen everyone
would want to be the

00:02:48.361 --> 00:02:51.592
buyers over here. We're
talking about $1050 price.

00:02:51.592 --> 00:02:53.562
That's right over here.
This was the price in

00:02:53.562 --> 00:02:55.467
the last example. Everyone
would want to be the

00:02:55.467 --> 00:02:58.270
buyer on the futures contract
or the forward contract.

00:02:58.270 --> 00:03:00.217
That would increase the price over there.

00:03:00.217 --> 00:03:04.108
Knowing you'd have less
buyers on the spot contract.

00:03:04.108 --> 00:03:07.129
That would decrease the price over there.

00:03:07.129 --> 00:03:11.186
In general this price
seems too low. The price

00:03:11.186 --> 00:03:14.123
at which people would
be neutral is if this

00:03:14.123 --> 00:03:18.689
price was $50 higher.
Then it becomes completely

00:03:18.689 --> 00:03:21.787
equivalent. A rational lower
bound given all of this,

00:03:21.787 --> 00:03:27.020
would have been a price of $1100. $1100.

00:03:27.020 --> 00:03:29.108
In general just going
back to the last video,

00:03:29.108 --> 00:03:31.921
a ration upper bound
will be the spot price

00:03:31.921 --> 00:03:34.986
plus the carrying cost
and the rate at which

00:03:34.986 --> 00:03:38.388
someone could borrow money.
A rational lower bound

00:03:38.388 --> 00:03:48.669
will be the spot price
plus the risk-free interest

00:03:48.669 --> 00:03:50.953
rate and the carrying
cost. In general, the only

00:03:50.953 --> 00:03:53.162
difference between those
upper and lower bound

00:03:53.162 --> 00:03:57.156
is this rate and this rate.
This rate and this rate.

00:03:57.156 --> 00:03:59.389
If these were the same the rational price

00:03:59.389 --> 00:04:02.735
would be the same. If
these both were 10%, then

00:04:02.735 --> 00:04:06.122
the rational price would
$1150. These were both

00:04:06.122 --> 00:04:08.945
5% the rational price, the
upper and the lower bound

00:04:08.945 --> 00:04:11.594
would have been $1100.


Futures curves II

WEBVTT
Kind: captions
Language: en

00:00:00.617 --> 00:00:02.696
Voiceover: I want to use this
video to try to get a better

00:00:02.696 --> 00:00:05.530
intuition for futures curves
and in particular to understand

00:00:05.530 --> 00:00:08.869
that the futures curves
shows a snapshot in time

00:00:08.869 --> 00:00:12.613
of the different market
prices for the, essentially

00:00:12.613 --> 00:00:16.280
the delivery price at different
future dates and when I

00:00:16.280 --> 00:00:18.364
say that, I know it was a
kind of confusing statement.

00:00:18.364 --> 00:00:20.614
In this futures curve right over here,

00:00:20.614 --> 00:00:23.363
when you have a delivery date
that's 0 months from now,

00:00:23.363 --> 00:00:26.614
that's essentially today,
that's the market price.

00:00:26.614 --> 00:00:29.735
That is the actual market
price of that commodity.

00:00:29.735 --> 00:00:32.362
In this example, the commodity is silver.

00:00:32.362 --> 00:00:34.614
So if you were to go out
and buy silver today,

00:00:34.614 --> 00:00:38.279
it would cost you roughly
$32, let me say that this is

00:00:38.279 --> 00:00:41.391
per ounce. It would
cost you $32 per ounce.

00:00:41.391 --> 00:00:43.990
When I say one out here, this is one month

00:00:43.990 --> 00:00:47.722
in the future. I'm not
talking about the price.

00:00:47.722 --> 00:00:50.454
I'm not talking about the spot
price of silver in a month.

00:00:50.454 --> 00:00:54.287
I'm talking about the
price today in the market,

00:00:54.287 --> 00:00:58.590
if you were to agree to buy
or sell silver in a month.

00:00:58.590 --> 00:01:02.268
The futures price for a
delivery one month out,

00:01:02.268 --> 00:01:03.784
that's what that is right now.

00:01:03.784 --> 00:01:06.117
So I want to make it very
clear. This is not showing you

00:01:06.117 --> 00:01:11.323
how the spot price of silver will
move over the next eight months.

00:01:11.323 --> 00:01:14.691
It's telling you today. If you
wanted to transact in silver

00:01:14.691 --> 00:01:17.515
right now, you would
transact at $32 an ounce.

00:01:17.515 --> 00:01:22.316
If today you agree to transact
in silver a month from now,

00:01:22.316 --> 00:01:23.974
you would transact, you would buy or sell,

00:01:23.974 --> 00:01:26.581
it looks at around $33 an ounce.

00:01:26.581 --> 00:01:30.983
If today you were to agree
to buy or sell silver

00:01:30.983 --> 00:01:35.315
four months from now, you
would do it at $35 an ounce.

00:01:35.315 --> 00:01:37.607
If today, I don't want to
be redundant, but if today

00:01:37.607 --> 00:01:40.917
you were to agree buy or sell
silver eight months from now

00:01:40.917 --> 00:01:43.142
and you were to lock in the
price, you would lock in a

00:01:43.142 --> 00:01:46.557
price, it looks it about I
don't know, $36 an ounce.

00:01:46.557 --> 00:01:49.848
So this is really a snapshot
in time and if for example,

00:01:49.848 --> 00:01:52.325
let's say tomorrow, the price
of silver, there's this huge

00:01:52.325 --> 00:01:55.184
silver shortage or people
realize a new application for

00:01:55.184 --> 00:01:57.871
silver that can change the
world then what you would have

00:01:57.871 --> 00:02:00.582
tomorrow is that this whole
curve would probably shift up.

00:02:00.582 --> 00:02:03.537
The whole curve would shift
up something like that,

00:02:03.537 --> 00:02:05.984
so no matter when you decide
to actually transact in

00:02:05.984 --> 00:02:08.717
the silver, it'll actually get
more expensive but I want to

00:02:08.717 --> 00:02:11.819
make it very clear that this
is just a snapshot in time

00:02:11.819 --> 00:02:14.915
and to better understand that,
I've also drawn over here

00:02:14.915 --> 00:02:17.870
how the prices can move it
over time and I've drawn

00:02:17.870 --> 00:02:21.650
different durations. So
in purple right over here,

00:02:21.650 --> 00:02:24.716
I've drawn the spot price. So
this is the spot price today

00:02:24.716 --> 00:02:27.453
and over here, this is the spot
price today but then I've shown

00:02:27.453 --> 00:02:30.850
how it changes in time. So
this is kind of closer to a

00:02:30.850 --> 00:02:34.890
traditional stock chart. This
just tells us that look, the stock

00:02:34.890 --> 00:02:38.699
price started at $32 and went
up a little bit, went down

00:02:38.699 --> 00:02:41.057
a little bit. It kind of just
goes up and down, oscillates

00:02:41.057 --> 00:02:44.004
a bit over the next eight
months. So this is actual

00:02:44.004 --> 00:02:47.871
movement over time. This is
a snapshot of delivery dates

00:02:47.871 --> 00:02:51.473
at some point in the future.
So the spot price just moves

00:02:51.473 --> 00:02:54.927
around and let's just take this
green contract right over here.

00:02:54.927 --> 00:02:58.394
So when we start on the first
day, the green contract,

00:02:58.394 --> 00:03:01.662
if you agree to transact in
silver four months from now,

00:03:01.662 --> 00:03:05.527
you're agreeing to transact at about $34.

00:03:05.527 --> 00:03:07.699
So that's where you
would transact right now,

00:03:07.699 --> 00:03:11.547
that four month out contract,
but as you move few -

00:03:11.547 --> 00:03:13.514
as you move more and more forward in time,

00:03:13.514 --> 00:03:16.139
you're getting closer and
closer to that delivery date.

00:03:16.139 --> 00:03:18.057
If you move one month into the future,

00:03:18.057 --> 00:03:20.390
now that contract is only
going to be three months out.

00:03:20.390 --> 00:03:21.514
You move two months in the future,

00:03:21.514 --> 00:03:23.514
now that contract is only two months out.

00:03:23.514 --> 00:03:26.056
All the way until, if
you move four months out,

00:03:26.056 --> 00:03:30.390
this contract will now be
essentially the spot price

00:03:30.390 --> 00:03:33.460
because you're now
agreeing to transact now.

00:03:33.460 --> 00:03:35.249
That'll happen four months
from now, but you'll now

00:03:35.249 --> 00:03:37.933
be agreeing to transact at that
moment and so at that moment,

00:03:37.933 --> 00:03:40.415
that price should be the
same as the spot price,

00:03:40.415 --> 00:03:43.200
so you'll have this
convergent with the spot price

00:03:43.200 --> 00:03:44.985
and the same thing for the
eight month out contract,

00:03:44.985 --> 00:03:49.789
it should converge over
the next eight months.


Contango and backwardation review

WEBVTT
Kind: captions
Language: en

00:00:00.541 --> 00:00:02.805
Voiceover: Let's do a quick
review of contango and

00:00:02.805 --> 00:00:05.472
backwardation because they
really are opposites of each

00:00:05.472 --> 00:00:08.005
other, but they're used in
different context, sometimes

00:00:08.005 --> 00:00:10.206
with the exact right meaning,
sometimes with the not so

00:00:10.206 --> 00:00:12.804
right meaning, so let's clarify
what we're talking about.

00:00:12.804 --> 00:00:17.404
So if you hear a commodities
trader say that a market

00:00:17.404 --> 00:00:21.537
is in contango, they're normally
just referring to the fact

00:00:21.537 --> 00:00:24.738
that you have an upward
sloping futures curve.

00:00:24.738 --> 00:00:27.190
So technically it'd be just
you would call it a normal

00:00:27.190 --> 00:00:29.357
futures curve because it's
upward sloping. They would

00:00:29.357 --> 00:00:32.205
call it contango. It sounds a
little fancier and if you were

00:00:32.205 --> 00:00:35.869
to hear a commodities trader
say that a market is in

00:00:35.869 --> 00:00:38.861
backwardation, they're
really just talking about an

00:00:38.861 --> 00:00:41.125
inverted futures curve.
They're just talking about

00:00:41.125 --> 00:00:44.945
something like this. Now, if
we were to be more precise

00:00:44.945 --> 00:00:47.695
with those, that's how it's
used in kind of common every

00:00:47.695 --> 00:00:50.124
day lingo but if you
wanted to be more precise,

00:00:50.124 --> 00:00:53.610
if someone were to tell you
that we're to talk about

00:00:53.610 --> 00:00:57.526
contango theory ... contango
theory may be in an academic

00:00:57.526 --> 00:01:00.724
setting, then they're talking
about the notion that the

00:01:00.724 --> 00:01:05.902
future delivery price is
actually higher than what people

00:01:05.902 --> 00:01:09.267
expect the price to be at that
date. The problem with that

00:01:09.267 --> 00:01:12.002
is it's just a theory and
there's no way to know ahead of

00:01:12.002 --> 00:01:14.936
time what that expected price
actually was, so it's very

00:01:14.936 --> 00:01:18.777
theoretical. Similarly, if
someone is talking about

00:01:18.777 --> 00:01:21.987
backwardation theory or even,
I guess more particularly if

00:01:21.987 --> 00:01:25.258
they use the word "normal"
backwardation. If they say

00:01:25.258 --> 00:01:28.488
the theory of normal
backwardation, they just don't say

00:01:28.488 --> 00:01:31.322
backwardation by itself.
They say the theory of normal

00:01:31.322 --> 00:01:34.737
backwardation, they're talking
about the idea that the

00:01:34.737 --> 00:01:39.107
future delivery price is
lower than some expected price

00:01:39.107 --> 00:01:43.261
because the seller is willing
to sell it at discount so they

00:01:43.261 --> 00:01:45.796
can essentially lock their
prices in, but once again it's

00:01:45.796 --> 00:01:50.020
a very theoretical idea and
it's really hard to observe it

00:01:50.020 --> 00:01:52.102
in the real world because
you actually don't know

00:01:52.102 --> 00:01:54.528
what the expected price
is. So if someone is saying

00:01:54.528 --> 00:01:56.861
backwardation, they're usually
just talking about an inverted,

00:01:56.861 --> 00:02:00.915
an inverted futures curve.
If someone talks about normal

00:02:00.915 --> 00:02:03.885
backwardation or the theory
of normal backwardation,

00:02:03.885 --> 00:02:07.379
they're talking about the idea
that the future price, the

00:02:07.379 --> 00:02:10.919
future delivery price is below
the market's expected price.

00:02:10.919 --> 00:02:14.850
I've even seen the word
"normal contango" used when

00:02:14.850 --> 00:02:18.203
they're talking about contango
theory. The idea that the

00:02:18.203 --> 00:02:21.002
future price would be above
the expected price, so

00:02:21.002 --> 00:02:24.467
contango theory is the
opposite of the theory of

00:02:24.467 --> 00:02:27.799
normal backwardation. Now,
for both of the theories,

00:02:27.799 --> 00:02:29.703
you never know what this
expected price is, so you can't

00:02:29.703 --> 00:02:33.464
literally observe it, a
snapshot in real time and the

00:02:33.464 --> 00:02:37.666
closest thing we can do
to observing either a real

00:02:37.666 --> 00:02:40.769
contango in a market or
real normal backwardation

00:02:40.769 --> 00:02:45.852
in a market, is if in the
example of contango, if the

00:02:45.858 --> 00:02:49.266
future delivery price right now
is higher than the expected.

00:02:49.266 --> 00:02:52.192
As we get closer and closer
to that delivery date,

00:02:52.192 --> 00:02:55.659
it should converge or it
should move down so you can

00:02:55.659 --> 00:02:59.391
kind of observe contango
over time when this price

00:02:59.391 --> 00:03:02.102
moves down as we go forward
in time. This is a snapshot.

00:03:02.102 --> 00:03:05.102
This is it moving it down
... moving down as we move

00:03:05.102 --> 00:03:09.470
ahead in time. Same thing
for normal backwardation.

00:03:09.470 --> 00:03:11.457
The only way that you can
really observe it or even

00:03:11.457 --> 00:03:14.325
attempt to observe it, is
to look at what happens to

00:03:14.325 --> 00:03:17.992
this price over time. If eight
months, the deliver price

00:03:17.992 --> 00:03:21.392
is $50, but as we move future
... as we move forward in

00:03:21.392 --> 00:03:24.943
time and that contract becomes
closer and closer to its

00:03:24.943 --> 00:03:28.058
actual delivery date. It will
converge with the spot price

00:03:28.058 --> 00:03:32.027
and it will move up, so this
observation of the futures

00:03:32.027 --> 00:03:34.724
price moving up as you
get closer to delivery,

00:03:34.724 --> 00:03:39.026
that's a better way of
observing that a market is

00:03:39.026 --> 00:03:41.394
experiencing normal
backwardation. Hopefully that

00:03:41.394 --> 00:03:43.255
clarifies some things.


Backwardation

WEBVTT
Kind: captions
Language: en

00:00:00.738 --> 00:00:02.462
Voiceover: What I've
drawn right here is an

00:00:02.462 --> 00:00:05.138
inverted oil futures curve.

00:00:05.138 --> 00:00:08.387
So if the futures curve looks
like this, it just means that it's

00:00:08.387 --> 00:00:13.052
more expensive to buy oil
today than to agree to buy

00:00:13.052 --> 00:00:15.802
oil at some future date,
two months from now,

00:00:15.802 --> 00:00:18.135
four months from now or
eight months from now.

00:00:18.135 --> 00:00:20.435
There's a couple of reasons
why this might happen.

00:00:20.435 --> 00:00:22.770
The most common reason
might just be there might be

00:00:22.770 --> 00:00:24.601
some type of shortage
right now for whatever

00:00:24.601 --> 00:00:28.886
reason, maybe ... maybe there's
a war going on and all of a

00:00:28.886 --> 00:00:32.305
sudden we need a lot more
fuel to support all of the

00:00:32.305 --> 00:00:36.326
crazy machinery and all of
that or maybe some oil got

00:00:36.326 --> 00:00:39.288
destroyed, maybe some oil
wells are burning. Who knows?

00:00:39.288 --> 00:00:40.993
There might be some type
of shortage, so people are

00:00:40.993 --> 00:00:44.326
willing to pay a premium
for oil right now.

00:00:44.326 --> 00:00:48.137
The other reason why you
might have an inverted oils

00:00:48.137 --> 00:00:50.992
future curve and this will
actually gel a little bit more

00:00:50.992 --> 00:00:54.219
with kind of what we're going
to talk about in this video

00:00:54.219 --> 00:00:59.259
is that people expect the price
of oil in the future to not

00:00:59.259 --> 00:01:01.471
be that different than the
price of oil today. If you were

00:01:01.471 --> 00:01:04.993
to go out there and survey
everyone who might be a seller

00:01:04.993 --> 00:01:07.659
or buyer of oil in the
world, which is obviously not

00:01:07.659 --> 00:01:10.201
possible, but if you were to ask them,

00:01:10.201 --> 00:01:13.326
"What is the expected price
of oil in eight months?",

00:01:13.326 --> 00:01:15.903
they might say, "Hey, okay we
might even have a little shortage

00:01:15.903 --> 00:01:20.551
"right now, but we expect
the price of oil to be $100."

00:01:20.551 --> 00:01:23.403
and so you might say, "Wait.
If everyone expects ...

00:01:23.403 --> 00:01:27.269
"If everyone expects the
price of oil to be $100,"

00:01:27.269 --> 00:01:30.205
"why are there some people
in the futures markets today"

00:01:30.205 --> 00:01:33.559
"who are agreeing to
sell the oil for $50?"

00:01:33.559 --> 00:01:37.675
"They're agreeing to sell it
below the expected price."

00:01:37.675 --> 00:01:39.673
And the reason why they
might be willing to, maybe

00:01:39.673 --> 00:01:43.426
their oil producers and oil
is such a volatile price and

00:01:43.426 --> 00:01:46.005
because they are dependent
on oil revenues to support

00:01:46.005 --> 00:01:49.401
the people who live in that
country or whatever else.

00:01:49.401 --> 00:01:52.339
They're essentially, in order
to guarantee the price and

00:01:52.339 --> 00:01:55.201
and not be susceptible to the
volatility, they're willing to

00:01:55.201 --> 00:01:59.342
sell it at a discount, to this
theoretical expected price.

00:01:59.342 --> 00:02:03.070
So either way, this could lead
to an inverted futures curve.

00:02:03.070 --> 00:02:06.986
Now, in kind of common lingo
when people see an inverted

00:02:06.986 --> 00:02:09.982
futures curve like this,
they'll often use the word

00:02:09.982 --> 00:02:14.453
"backwardation", backwardation.
They'll say that the

00:02:14.453 --> 00:02:18.121
future ... that this futures
market is in backwardation,

00:02:18.121 --> 00:02:22.388
so backwardation and what I
want to be clear is, is that

00:02:22.388 --> 00:02:24.386
that's what most people
are talking about, inverted

00:02:24.386 --> 00:02:27.053
futures curve but that's not
exactly right if you we want

00:02:27.053 --> 00:02:30.719
to give the precise academic
definition. The precise

00:02:30.719 --> 00:02:33.387
definition is not just an
inverted curve, the precise

00:02:33.387 --> 00:02:36.601
definition is and this is
actually the theory of normal

00:02:36.601 --> 00:02:40.352
backwardation. It came from
Keynes and that is, is that

00:02:40.352 --> 00:02:43.933
the sellers are willing to sell
in the future at a discount

00:02:43.933 --> 00:02:47.185
to the expected price because
of the volatility, so that

00:02:47.185 --> 00:02:50.721
they could lock in their
price. So the theory of normal

00:02:50.721 --> 00:02:53.652
backwardation is actually
this phenomenon right here.

00:02:53.652 --> 00:02:56.454
But this is actually not
observable because you can't go

00:02:56.454 --> 00:02:58.549
and survey everyone
and figure out what the

00:02:58.549 --> 00:03:00.933
actual expected price is
and you can see that they're

00:03:00.933 --> 00:03:03.253
often one and the same. The
expectant price was here.

00:03:03.253 --> 00:03:06.708
You had an inverted futures
curve. That's why they called

00:03:06.708 --> 00:03:10.601
this curve that or this
market in backwardation.

00:03:10.601 --> 00:03:13.517
The one way that you can
kind of observe it, is if you

00:03:13.517 --> 00:03:17.985
see, so over here, this is our
spot price. This is our spot

00:03:17.985 --> 00:03:20.388
price and now we're moving
over time and you can see

00:03:20.388 --> 00:03:23.101
the spot price isn't changing
much and because it's not

00:03:23.101 --> 00:03:27.008
changing much, this cheaper
futures price, as we move

00:03:27.008 --> 00:03:29.892
closer and closer to its
delivery date, it has to

00:03:29.892 --> 00:03:32.853
converge with the spot price.
As this one right over here

00:03:32.853 --> 00:03:36.966
it starts at $75, as you go
further and further in time,

00:03:36.966 --> 00:03:40.002
it has to converge to the
spot price and so when you see

00:03:40.002 --> 00:03:44.477
the futures price moving
up towards the spot price,

00:03:44.477 --> 00:03:47.919
over as it gets closer and
closer to its delivery date,

00:03:47.919 --> 00:03:50.521
that's maybe the most
observable way that you could

00:03:50.521 --> 00:03:53.719
say that the market is
experiencing ... is experiencing

00:03:53.719 --> 00:03:55.670
backwardation.


Contango

WEBVTT
Kind: captions
Language: en

00:00:00.661 --> 00:00:05.597
Contango can be one of the more difficult to comprehend ideas

00:00:05.597 --> 00:00:08.339
when we talk about futures markets, but it's really because

00:00:08.339 --> 00:00:10.876
it's used in different contexts all the time,

00:00:10.876 --> 00:00:12.910
with slightly different meanings depending upon

00:00:12.910 --> 00:00:16.397
whether you're talking about someone participating in a futures market

00:00:16.397 --> 00:00:18.743
or whether an academic is talking about it,

00:00:18.743 --> 00:00:21.160
but first let me give you the proper definition.

00:00:21.160 --> 00:00:25.979
So the proper definition of contango, it's actually a theory

00:00:25.979 --> 00:00:29.572
and it really can't be observed.

00:00:29.572 --> 00:00:35.404
And Contango Theory says that people are willing to pay more

00:00:35.404 --> 00:00:39.167
to buy some commodity in the future

00:00:39.167 --> 00:00:42.350
than the actually expected price of that commodity

00:00:42.350 --> 00:00:46.800
so, when we talk about expected price, this is a very theoretical thing

00:00:46.800 --> 00:00:49.515
if you were to go and survey everyone participating

00:00:49.515 --> 00:00:50.915
in the futures market and say,

00:00:50.915 --> 00:00:55.242
"What price do you think silver will be in 8 months?"

00:00:55.242 --> 00:00:57.505
And if they all, you know, you took your survey,

00:00:57.505 --> 00:01:02.263
and they all told you the 100% answer, you could get this theoretical expected price

00:01:02.263 --> 00:01:06.334
and maybe that theoretical expected price is $33

00:01:06.334 --> 00:01:12.344
so this right here is the expected price of silver in the market

00:01:12.344 --> 00:01:14.999
and you could see from this futures curve right here

00:01:14.999 --> 00:01:20.731
that delivery, the silver futures contract for delivery

00:01:20.731 --> 00:01:22.840
(expected)

00:01:22.840 --> 00:01:25.839
for delivery 8 months from now is trading above that

00:01:25.839 --> 00:01:28.261
it's trading above the expected price,

00:01:28.261 --> 00:01:31.475
and it's probably trading above the expected price

00:01:31.475 --> 00:01:35.047
because people don't want to, people who what to have silver in 8 months

00:01:35.047 --> 00:01:40.099
they don't want to buy it today and have to go rent some space and have to store the silver

00:01:40.099 --> 00:01:42.332
and have to insure the silver, and worry about someone

00:01:42.332 --> 00:01:44.248
maybe stealing the silver, they'd rather

00:01:44.248 --> 00:01:48.039
just pay for a premium in order for it, to have it be delivered

00:01:48.039 --> 00:01:54.105
in the future. So this is kind of the correct academic description of Contango Theory

00:01:54.105 --> 00:01:58.198
The theory that the futures price, on a future delivery date,

00:01:58.198 --> 00:02:01.364
is going to be higher than what the market actually expects

00:02:01.364 --> 00:02:04.456
so people to some degree are paying a premium

00:02:04.456 --> 00:02:10.658
to have the delivery of the silver, to have it delayed.

00:02:10.658 --> 00:02:13.365
Now, in practice, you will hear people say that a market

00:02:13.365 --> 00:02:17.466
is "in contango," and usually what they are talking about

00:02:17.466 --> 00:02:19.352
they're usually talking about one of two things,

00:02:19.352 --> 00:02:23.260
and they're related, but usually if they're a little bit more correct about it

00:02:23.260 --> 00:02:27.888
they're talking about the idea that the futures price.

00:02:27.888 --> 00:02:33.300
is, over time, going to converge downward to the actual spot price

00:02:33.300 --> 00:02:35.949
So what I've done here, so this is the futures curve,

00:02:35.949 --> 00:02:39.635
so this is just the price, the delivery price of the different contracts

00:02:39.635 --> 00:02:41.893
going forward in time. But this is the delivery price,

00:02:41.893 --> 00:02:47.262
the market delivery price today, right now. This is how things trend over time

00:02:47.262 --> 00:02:51.313
so in magenta, I have the spot price trending over time

00:02:51.313 --> 00:02:55.069
right over there. And then you can see that you have the 4 month

00:02:55.069 --> 00:02:58.594
the contract that's for delivery in 4 months, today

00:02:58.594 --> 00:03:03.665
it's price is a little bit under $35, but as you approach it's actual delivery date

00:03:03.665 --> 00:03:05.652
so now we're actually moving forward in time

00:03:05.652 --> 00:03:07.619
it has to converge to the spot price,

00:03:07.619 --> 00:03:10.148
otherwise people could make free money on that day.

00:03:10.148 --> 00:03:12.235
And so the delivery date 8 months out,

00:03:12.235 --> 00:03:15.062
has to converge to the spot price eventually,

00:03:15.062 --> 00:03:18.338
and so what you see is, is because the spot price

00:03:18.338 --> 00:03:22.784
hasn't moved up a lot, and you see this downward converging of the different

00:03:22.784 --> 00:03:26.319
futures price, this is what people normally refer to

00:03:26.319 --> 00:03:29.892
when they say a market is in contango,

00:03:29.892 --> 00:03:33.207
when you see the delivery price of a certain futures contract

00:03:33.207 --> 00:03:37.354
converge downward to the actual spot price

00:03:37.354 --> 00:03:39.728
so all of these are converging downward over time

00:03:39.728 --> 00:03:41.751
so it's something that you would have to observe over time

00:03:41.751 --> 00:03:45.285
not something that you would traditionally just be able to look at a futures curve

00:03:45.285 --> 00:03:47.642
but in general when you have this,

00:03:47.642 --> 00:03:50.769
you normally see that the futures delivery prices are

00:03:50.769 --> 00:03:54.056
higher the further out you go, so you have this upward

00:03:54.056 --> 00:03:55.655
sloping futures curve.

00:03:55.655 --> 00:03:59.208
So the simplest kind of analysis when people say something is "in contango,"

00:03:59.208 --> 00:04:01.239
they'll just look at an upward sloping futures curve

00:04:01.239 --> 00:04:02.720
or a normal curve

00:04:02.720 --> 00:04:05.180
and then say "this is also in contango"

00:04:05.180 --> 99:59:59.999
but this isn't exactly right, it's really this movement over time.


Futures and forward curves

WEBVTT
Kind: captions
Language: en

00:00:00.403 --> 00:00:01.808
Male voiceover: Let's
see if we can understand

00:00:01.808 --> 00:00:04.078
a thing or two about Futures Curves

00:00:04.078 --> 00:00:06.162
and I've drawn two futures curves here

00:00:06.162 --> 00:00:11.386
and really all they show is
the different settlement prices

00:00:11.386 --> 00:00:14.752
for the different
delivery dates of futures.

00:00:14.752 --> 00:00:17.080
So, let's say that this
orange curve is one of them.

00:00:17.080 --> 00:00:21.583
What this says is if today,
if for delivery today,

00:00:21.583 --> 00:00:24.074
we wanted to buy or sell an apple,

00:00:24.074 --> 00:00:25.996
the market rate is 10 cents a pound.

00:00:25.996 --> 00:00:27.781
This isn't the Futures contract at all.

00:00:27.781 --> 00:00:29.786
This is actually called the Spot Price.

00:00:29.786 --> 00:00:33.210
It's essentially the market
price for that commodity

00:00:33.210 --> 00:00:34.494
or that security today.

00:00:34.494 --> 00:00:36.149
We're just using the example of apples.

00:00:36.149 --> 00:00:39.489
This tells us at time 0, you
can buy or sell an apple,

00:00:39.489 --> 00:00:41.449
based on the current market for 10 cents.

00:00:41.449 --> 00:00:44.736
Now, when we move to 1, the
way I've labeled this axis,

00:00:44.736 --> 00:00:47.258
it says one month from now.

00:00:47.258 --> 00:00:49.919
This is not saying that
the market price is going

00:00:49.919 --> 00:00:51.385
to go up one month from now.

00:00:51.385 --> 00:00:53.270
This is saying that today,

00:00:53.270 --> 00:00:55.586
if you were to go into the Futures market

00:00:55.586 --> 00:00:59.427
and say, "I want to sell,"
or, "I want to buy apples

00:00:59.427 --> 00:01:00.920
"one month from now.

00:01:00.920 --> 00:01:02.851
"What type of a settlement price

00:01:02.851 --> 00:01:04.534
"can I get on my Futures contract?"

00:01:04.534 --> 00:01:06.745
And based on this Futures Curve,

00:01:06.745 --> 00:01:09.492
it looks like we could do about 12 cents.

00:01:09.492 --> 00:01:12.572
I'm gonna repeat what I just said.

00:01:12.572 --> 00:01:16.145
This is not saying that a month from now

00:01:16.145 --> 00:01:17.600
that the market price

00:01:17.600 --> 00:01:19.331
that the Spot Price is going to move up.

00:01:19.331 --> 00:01:21.343
Only this time 0 is the Spot Price.

00:01:21.343 --> 00:01:23.835
What this is saying is right now,

00:01:23.835 --> 00:01:25.313
the market is saying,
"If you want to enter

00:01:25.313 --> 00:01:28.236
"into a Futures contract for
delivery a month from now,

00:01:28.236 --> 00:01:32.135
"that delivery price will be 12 cents.

00:01:32.135 --> 00:01:34.391
"If you wanna deliver two months from now,

00:01:34.391 --> 00:01:36.693
that delivery price
might be around 15 cents.

00:01:36.693 --> 00:01:39.103
"If you wanna deliver
eight months from now,

00:01:39.103 --> 00:01:42.324
"that delivery price might
be something like 20 cents."

00:01:42.324 --> 00:01:43.789
If you wanted to show movement,

00:01:43.789 --> 00:01:45.499
let's say all of a sudden,

00:01:45.499 --> 00:01:47.209
people just get more bullish on apples

00:01:47.209 --> 00:01:49.426
or there's some new
diet that tells everyone

00:01:49.426 --> 00:01:51.239
that apples help you lose weight,

00:01:51.239 --> 00:01:53.443
what you would probably see is

00:01:53.443 --> 00:01:55.907
this entire curve would shift up

00:01:55.923 --> 00:01:58.175
So, regardless of delivery date,

00:01:58.175 --> 00:02:01.250
you would probably see
this entire curve shift up

00:02:01.250 --> 00:02:02.988
because people would want apples

00:02:02.988 --> 00:02:06.584
across the entire Futures Curve.

00:02:06.584 --> 00:02:08.521
This one that we're
highlighting right now,

00:02:08.521 --> 00:02:09.987
I've drawn two Futures Curves.

00:02:09.987 --> 00:02:12.523
I've drawn an upwards sloping orange one

00:02:12.523 --> 00:02:14.987
and I've also drawn a
downward sloping blue one

00:02:14.987 --> 00:02:16.671
and I'll focus on that
one in the next video

00:02:16.671 --> 00:02:20.395
but this upward sloping
is kind of a normal curve

00:02:20.395 --> 00:02:21.651
and it's actually called that.

00:02:21.651 --> 00:02:24.659
It's a Normal Curve because
this is what you actually expect

00:02:24.659 --> 00:02:27.051
for most types of commodities.

00:02:27.051 --> 00:02:27.999
You could imagine why.

00:02:27.999 --> 00:02:32.076
If this wasn't upward sloping,

00:02:32.076 --> 00:02:33.722
there would actually be no reason for you

00:02:33.722 --> 00:02:34.632
to hold onto something.

00:02:34.632 --> 00:02:35.910
Especially, if this was downwards sloping,

00:02:35.910 --> 00:02:37.269
you'd be like, "Wow.

00:02:37.269 --> 00:02:38.459
"If for future delivery dates,

00:02:38.459 --> 00:02:39.746
"I'm getting lower and lower prices,

00:02:39.746 --> 00:02:41.602
"why don't I just sell now?"

00:02:41.618 --> 00:02:43.899
And that would actually
create downward pressure

00:02:43.899 --> 00:02:45.400
on the current Spot Price

00:02:45.400 --> 00:02:48.144
and you could of course, make
the arbitrage arguments I made

00:02:48.144 --> 00:02:51.761
in previous videos, why you
shouldn't in a theoretical setting,

00:02:51.761 --> 00:02:54.666
see a downward sloping Futures Curve.

00:02:54.666 --> 00:02:57.410
What we're gonna talk a little
bit about on the next video,

00:02:57.410 --> 00:03:01.151
is maybe why you would see a
downward sloping Futures Curve

00:03:01.151 --> 00:03:05.164
where the delivery price
for delivery further out

00:03:05.164 --> 00:03:07.237
than the Spot Price or
for further out months

00:03:07.237 --> 00:03:09.769
than nearby months is actually lower

00:03:09.769 --> 00:03:11.376
and just to give you a little terminology,

00:03:11.376 --> 00:03:14.789
this type of curve right here
is called an Inverted Curve

00:03:14.789 --> 00:03:16.252
and I'll talk in the next video on

00:03:16.252 --> 23:59:59.999
why you might see one of those.


Verifying hedge with futures margin mechanics

WEBVTT
Kind: captions
Language: en

00:00:00.560 --> 00:00:02.840
Let's verify that
the margin mechanics

00:00:02.840 --> 00:00:06.190
in the marking to market
of the futures contract

00:00:06.190 --> 00:00:09.340
actually gets both the seller
and the buyer what they

00:00:09.340 --> 00:00:11.900
originally wanted, which
is that they don't have

00:00:11.900 --> 00:00:15.830
to be susceptible to the
volatility in apple prices.

00:00:15.830 --> 00:00:18.660
They both wanted
to, effectively,

00:00:18.660 --> 00:00:22.270
sell the apples for $0.20
a pound or buy the apples

00:00:22.270 --> 00:00:23.530
for $0.20 a pound.

00:00:23.530 --> 00:00:25.610
And they didn't want to,
in the farmer's case,

00:00:25.610 --> 00:00:28.234
go out of business if they could
only sell the apples for $0.10

00:00:28.234 --> 00:00:30.230
a pound, or in the
pie company's case,

00:00:30.230 --> 00:00:33.040
go out of business if they had
to buy the apples for $0.30

00:00:33.040 --> 00:00:33.880
a pound.

00:00:33.880 --> 00:00:36.480
So let's verify
that this works out.

00:00:36.480 --> 00:00:38.130
So they originally
had a contract price

00:00:38.130 --> 00:00:39.870
of $200 for 1,000 pounds.

00:00:39.870 --> 00:00:43.810
So this is essentially
$0.20 a pound.

00:00:43.810 --> 00:00:46.090
And as we said in
the previous video,

00:00:46.090 --> 00:00:49.310
as the futures contract
delivery price changes day

00:00:49.310 --> 00:00:53.380
by day, as we get closer and
closer to the actual delivery

00:00:53.380 --> 00:00:55.710
date, what happens
is that we transfer

00:00:55.710 --> 00:00:58.690
money between the buyer's margin
account and the seller's margin

00:00:58.690 --> 00:01:00.420
account.

00:01:00.420 --> 00:01:02.460
As the delivery price
of the future contract

00:01:02.460 --> 00:01:06.860
goes down, in order to mark
the delivery price down--

00:01:06.860 --> 00:01:11.230
so in order to mark it down
from $200 to $190 to $185--

00:01:11.230 --> 00:01:14.100
this guy keeps getting a better
deal on the actual delivery

00:01:14.100 --> 00:01:14.790
price.

00:01:14.790 --> 00:01:18.040
So to make things fair, he has
to transfer the same amount

00:01:18.040 --> 00:01:20.920
of money to the margin
account of the seller.

00:01:20.920 --> 00:01:22.790
So let's imagine two scenarios.

00:01:22.790 --> 00:01:25.470
Let's say that
eventually, as we approach

00:01:25.470 --> 00:01:29.010
November 15-- remember,
this is the delivery date--

00:01:29.010 --> 00:01:30.497
the futures contract
delivery price

00:01:30.497 --> 00:01:32.080
is going to approach
the market price.

00:01:32.080 --> 00:01:34.360
You can imagine right
when we're like a second

00:01:34.360 --> 00:01:36.950
before the delivery date, the
futures contract and the market

00:01:36.950 --> 00:01:38.616
price aren't going
to be that different.

00:01:38.616 --> 00:01:44.000
And let's say that this goes
all the way down to $100.

00:01:44.000 --> 00:01:46.480
So in that whole process,
this futures contract

00:01:46.480 --> 00:01:48.630
keeps getting
marked down to $100.

00:01:48.630 --> 00:01:52.400
So on that day, it is
true that the seller

00:01:52.400 --> 00:01:56.990
will sell 1,000 pounds of apples
to the buyer for only $100.

00:01:56.990 --> 00:01:58.160
You might say, hey, wait.

00:01:58.160 --> 00:01:59.660
What did the seller
get out of this?

00:01:59.660 --> 00:02:03.280
He's only getting $0.10
per pound for his apples.

00:02:03.280 --> 00:02:04.309
This was what he feared.

00:02:04.309 --> 00:02:06.350
He is susceptible to the
volatility of the market

00:02:06.350 --> 00:02:07.080
prices.

00:02:07.080 --> 00:02:10.080
But remember, because of this
marking to market, and because

00:02:10.080 --> 00:02:14.750
of the margin transfers here,
as this delivery price went down

00:02:14.750 --> 00:02:17.420
from $200 to $100,
there would have

00:02:17.420 --> 00:02:20.300
been a transfer from
this guy's margin account

00:02:20.300 --> 00:02:25.620
to this guy's margin
account of $100.

00:02:25.620 --> 00:02:27.530
So instead of just
getting the $100

00:02:27.530 --> 00:02:30.910
for that 1,000 pounds of
apples, because this seller had

00:02:30.910 --> 00:02:32.910
this futures contract,
he would have also gotten

00:02:32.910 --> 00:02:36.650
another $100 transferred
into his margin account.

00:02:36.650 --> 00:02:42.300
So the true economic value he
gets is $200, no matter what,

00:02:42.300 --> 00:02:45.490
for his 1,000 pounds of
apples, or $0.20 a pound.

00:02:45.490 --> 00:02:47.430
You can imagine
the other scenario.

00:02:47.430 --> 00:02:50.230
What if the delivery price
as we get closer and closer

00:02:50.230 --> 00:02:52.330
to delivery date goes up?

00:02:52.330 --> 00:02:57.004
If it goes to $300
per 1,000 pounds?

00:02:57.004 --> 00:02:59.170
Well, you might say, hey,
the seller is going to get

00:02:59.170 --> 00:03:01.378
a bonanza, and this guy's
going to go out of business

00:03:01.378 --> 00:03:04.000
because he's going to be
essentially paying $0.30 per

00:03:04.000 --> 00:03:04.830
pound.

00:03:04.830 --> 00:03:08.040
But you gotta remember,
if the price went up

00:03:08.040 --> 00:03:10.500
and it becomes more and more
favorable to the seller,

00:03:10.500 --> 00:03:12.820
because of the margin
mechanics, the seller would

00:03:12.820 --> 00:03:18.080
have to transfer $100 over--
as the price moves up--

00:03:18.080 --> 00:03:21.260
to the buyer, to
his margin account.

00:03:21.260 --> 00:03:24.120
And so even though this guy
has to pay $300 per pound,

00:03:24.120 --> 00:03:26.590
because that's where the market
price eventually ended up,

00:03:26.590 --> 00:03:28.910
he would get $100
from the seller.

00:03:28.910 --> 00:03:32.900
So effectively, he would
still only have to pay $200.

00:03:32.900 --> 00:03:35.460
And even though this guy
is selling it for $300,

00:03:35.460 --> 00:03:38.010
he actually had to
pay another $100.

00:03:38.010 --> 00:03:40.980
So net, he's really only
getting $200 for it.

00:03:40.980 --> 00:03:43.930
So no matter how you look at
it, both parties are transacting

00:03:43.930 --> 00:03:47.470
at $200, or $0.20 a pound.