What Is A Futures Contract?
Futures contract refer to a legally enforceable agreement to buy or sell a specific commodity or security at a pre-determined price on a stated date. The settlement of these contracts primarily allows cash settlement instead of physical delivery.
A futures contract is a financial derivative between two parties where the quantity of an asset to buy and sell, price, and delivery date are pre-established. The underlying asset can be stocks, bonds, precious metals, currencies, and interest rates. The settlement of futures contracts primarily allows cash settlement instead of physical delivery.
Table of contents
- A futures contract is a legal agreement that binds a buyer and a seller to trade specific assets at a predetermined price and date in the future.
- There are four common types: currency, stock market index, commodity, and interest rate futures.
- It is used for speculative and hedging purposes since it helps to lock in a specific price.
- Forwards are different because forwards are non-standardized and traded over the counter, unlike futures that are standardized and traded through exchanges.
Futures Contract Explained
A futures contract is a derivatives contract obligating the buyer and the seller to transact the underlying asset at a pre-determined future date and price irrespective of market price at the expiration date. The buyer should buy and receive the underlying asset when the futures contract expires. The seller should deliver the underlying asset at the expiration date. Furthermore, it has a standard size. For example, the standard contract size for gold futures is 100 ounces.
Speculators and hedgers primarily use it. Using futures, speculators risk by betting on a future price, while hedgers try to reduce the risk by locking in a price. Furthermore, if the price of the underlying asset decreases, the seller is holding a short position then the seller benefits from the price drop. If the price of the underlying asset increases, then the buyer taking a long position can obtain the profit.
Types Of Futures Contract
#1 – Commodity Futures
It stipulates the commodity‘s price time and volume in the contract for both parties. The contract is generally cash settled. The three basic components of commodity futures are metal, food, and energy. For example, it can be gold, silver, crude oil, etc.
For commodities, it is essential because it reduces the risk faced by the buyers due to the probability of prices increasing in the future. Such contracts are sold on exchanges ensuring a safer trade. Companies use futures contracts to obtain a fixed price for commodities they buy from commodity producers.
#2 – Currency Futures
In these contracts, the underlying assets are currency exchange rate; the rate defines the exchange between any two currencies, for example, the US Dollar to the Euro exchange rate, the Indian Rupee to the English Pound rate, or the English Pound to the US Dollar rate. In essence, it is the contract to exchange one currency for the other.
The currency futures remain constant as in all other futures and are traded similarly. Such currencies are traded via currency brokers in exchanges like Chicago Mercantile Exchange.
#3 – Interest Rate Futures
These contracts concern interest-bearing financial instruments or debt instruments. They are used for hedging and speculative purposes. An example of the underlying instrument is treasury bills and treasury bonds. These futures are settled either way by cash or by physical delivery.
#4 – Stock Market Index Futures
These contracts are in context to the stock index, so the underlying asset is linked to a stock index. Future brokers trade these primarily for hedging, spread trading, speculating, etc. It is also a part of technical indicators denoting market emotion and sentiment.
Let’s understand it with a simple futures contract example:
Luther started a company that consistently requires silver, and his company is already in conversation with a company supplying silver. The silver provider uses a futures contract to bind Luther and his company, promising to sell a fixed quantity of silver at a pre-determined price and the time the delivery will be executed. Luther agrees to the contract. Now both of them are obligated to trade the silver in the future at a set price.
Futures vs Forward Contract
Both are contracts between two parties, helping them to hedge risk.
Let’s look into the difference between forward and futures contracts:
- Futures are standardized contracts with general rules and regulations of trading commodities, whereas forwards are non-standardized and customized contracts, ensuring the interest of both parties.
- Futures are traded on exchanges, while forwards are traded in the “over the counter” (OTC) market.
- The forward contract settles only once at the event of the maturity date. However, the settlement for futures contracts can occur over a range of dates.
- The level of risk is low in the future. At the same time, the risk is high in forwards.
- The liquidity is high in futures. In contrast, the liquidity is low in forwards.
- It requires an initial margin as collateral which is not in the case of forwards.
- The default risk is low, but in forward contracts, since they are more likely a private agreement, the probability of default is relatively high.
Frequently Asked Questions (FAQs)
The contracts made for future transactions are referred to as futures; it involves two parties involved in trading (buy or sell) particular security or asset in the future at a pre-determined price; the asset is only delivered at the set delivery date.
Suppose an iron producer and buyer agree to a certain amount of iron transaction to be traded in the future. The parties agree to a set price to trade the iron on a predetermined date in the future, also known as the delivery date. At the time of delivery, irrespective of the iron’s current price, the contract will be executed at a price agreed.
Futures markets are open for trade for almost 24 hours and six days a week. Usually, there is no futures trading on weekends, but in many countries, the futures market starts trading on Sunday evening, creating an effect of six days of trading. As a result, investors enjoy more flexibility in managing their positions because there is plenty of time for investors in the futures market.
This article is a guide to What is Futures Contract & its meaning. We explain its trading hours, types, an example, and comparison with the forward contract. You can learn more about derivatives from the following articles –