Futures Basics

A futures contract is an agreement between a buyer and a seller that the buyer will purchase some commodity at a fixed price on some fixed date. Conversely the opposite directional relationship is also true, meaning the seller agrees to sell that commodity to the buyer on that date for that price. It is a mutual obligation between two parties. It is not an option, which provides a right but not an obligation to sell or buy a stock at a certain price. Futures are obligations.

Over the years, the details of futures contracts used to differ from contract to contract depending on the parties involved. But nowadays, all of those details are completely standardized, with the obvious exceptions of the specific commodities being bought and sold and the agreed upon price. The standard details that are included in every futures contract are as follows: the exact commodity being sold, the quantity of said commodity, the quality, the delivery date agreed to by both parties, and whether the contract can be settled in goods or in cash. Futures contracts are traded on futures exchanges, with eight of these exchanges present in the United States.

Types of Futures Available

Agricultural commodity futures are a very common contract type. An example could be a grain future in which the seller agrees to provide some huge agreed upon load of some specified grain in exchange for a specified amount of money on a specified date in time. The seller has the obligation to deliver the product and the buyer is obligated to pay for it.

Foreign currency futures basically hedge a bet against the value of the Euro, for example, on a specific date. In the U.S., a buyer agrees to pay a certain amount of American money to buy some preset number of Euros at that agreed upon date.

Stock index futures are also bought and sold. Since an index is not really a commodity in the strictest sense, these are just settled in cash rather than an actual exchange of a physical commodity. Interest rate futures are similar to stock index futures in this way, so they are also settled in cash.  The value of this kind of stock option is typically measured with Black Sholes option pricing.

Benefits of Futures

Futures are basically designed to transfer risk from those who want less of it to those who are willing to take on more of it in exchange for the possibility (not the guarantee) of financial gain. As an example, in the grain future transaction the buyer is generally the one taking on all the risk on behalf of the seller. The seller (presumably a grower) gets assurance that his crop will be bought at some date in the future (in this example, around the time of the harvest). In return, however, he more than likely agrees to at least a slightly lower price than what his crop might otherwise fetch in the open market.

The buyer, on the other hand, risks much more by agreeing to a preset price and guaranteeing purchase. It is conceivable that the commodity being purchased will end up being worth much less than that price by the time it is bought and sold. But as previously mentioned the price normally favors the buyer, because by agreeing to take on the risk of being forced to make a purchase in the future, he gets essentially a discount on the projected market rate for that commodity being sold.

Of course, both buyers and sellers are at risk in any futures contract transaction. But their respective levels of risk are agreeable to both parties, each of whom is aware of that risk.

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