futures contract

What is Futures Contract?

Futures contract is a forward contract traded  on organised exchanges in standardized contract size.

Before understanding futures contract, it is very important that you should have the knowledge of short hedge and long hedge. Short hedge is a common occurrence in business. It takes place whenever a firm or an individual is holding goods or any other asset or is is expecting to receive the same. On the contrary long hedge occurs when a person or the firm is committed to sell at a fixed price.

Unlike options, futures are the obligations on the date the seller has to deliver to the buyer and buyer pays the seller agreed price. Here just like forward contracts, one party would lose and another will gain. The profit and loss will depend upon the agreed future price and the actual price at the time of contract maturity. In short and simple words, the seller of the contracts gains when the contract price is more than the actual market price later on. The buyer of the contract will gain when the contract price is less than the actual market price.

Example of Futures Contract

Suppose a farmer produce wheat. He is expecting to have an excellent yield of wheat but at the same time he is worried as well. He has concern for the future prices of wheat. He fears the fall in the prices of the crop. Now how he can protect himself from the falling price of wheat?

The answer is simple, he can do so by entering into a contract today with the person who wants to buy wheat for the delivery in future. Farmer agrees today to sell wheat to the buyer at  a specified future date at a price agreed upon today. The buyer is in a different position than the farmer. He is worried that wheat prices may increase in the future. He can fix the wheat price ahead of time and take delivery in the future. He would agree to buy wheat at a predetermined price on a specified date.

Both the farmer and the buyer are able to hedge their risk. The farmer has locked the selling price and the buyer has locked the buying price. So instead of worrying about the future prices of the wheat, they can concentrate on their operations.