What is a ‘Futures Contract’
A futures contract is a legal agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future. Futures contracts are standardized to facilitate trading on a futures exchange and, depending on the underlying asset being traded, detail the quality and quantity of the commodity.
BREAKING DOWN ‘Futures Contract’
Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The terms “futures contract” and “futures” refer to essentially the same thing. For example, you might hear somebody say he bought oil futures, which means the same thing as an oil futures contract. To get more specific, one could say that a futures contract refers only to the specific characteristics of the underlying asset being traded, while “futures” is more general and can also refer to the overall market as in: “He’s a futures trader.”
Example of Futures Contracts
Futures contracts are used by two categories of market participants: hedgers and speculators. Producers or purchasers of an underlying asset hedge or guarantee the price at which the commodity is sold or purchased, while portfolio managers or traders may also make a bet on the price movements of an underlying asset using futures.
Many different assets have futures contracts available. Futures contracts on dozens of different major stock market indices around the world are traded, as well as futures on the major currency pairs and major interest rates. As for commodities, a large number of contracts are available for just about every commodity produced. For example, industrial metals, precious metals, oil, natural gas and other energy products, oils, seeds, grains, livestock and even carbon credits all have tradable futures contracts available.
Mechanics of a Futures Contract
Imagine an oil producer plans to produce 1 million barrels of oil ready for delivery in exactly 365 days. Assume the current price is $50 per barrel. The producer could take a gamble, produce the oil, and then sell it at the current market prices one year from today. Given the volatility of oil prices, the market price at that time could be at any level. Instead of taking chances, the oil producer could lock-in a guaranteed sale price by entering into a futures contract. A mathematical model is used to price futures, which takes into account the current spot price, the risk-free rate of return, time to maturity, storage costs, dividends, dividend yields and convenience yields. Assume that the one-year oil futures contracts are priced at $53 per barrel. By entering into this contract, in one year, the producer is obligated to deliver 1 million barrels of oil and is guaranteed to receive $53 million. The $53 price per barrel is received regardless of where spot market prices are at the time.