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What is a Futures Contract?
A Futures Contract represents a standardized legal agreement to buy or sell a specific asset at a predetermined price on a specified future date. Futures contracts are traded on regulated exchanges and are commonly used for hedging risk or speculative purposes.
Definition
Futures Contract is an exchange-traded derivative agreement that obligates the buyer to purchase, and the seller to deliver, an asset at a fixed price on a future date.
Key Takeaways
- Futures contracts are standardized and exchange-traded.
- They are used to hedge price risk or speculate on price movements.
- Daily settlement (mark-to-market) reduces counterparty risk.
Understanding Futures Contracts
Futures contracts are widely used across commodities, financial instruments, and currencies. Unlike forward contracts, futures are standardized in terms of contract size, delivery dates, and quality specifications, and they trade on organized exchanges such as the CME or ICE.
Participants post margin to enter positions, and gains or losses are settled daily through the exchange’s clearinghouse. This structure greatly reduces default risk compared to over-the-counter derivatives.
Common users include producers and consumers hedging price risk (e.g., farmers, airlines) and traders seeking profit from price volatility.
Formula (If Applicable)
Futures Price (Cost-of-Carry Model):
Futures Price = Spot Price × (1 + Risk-Free Rate + Storage Costs − Convenience Yield) ^ Time
Margin Requirement:
Initial Margin + Variation Margin = Total Margin Posted
Real-World Example
A wheat farmer sells wheat futures to lock in a selling price ahead of harvest, protecting against falling prices. At the same time, a food manufacturer buys futures to secure predictable input costs.
Importance in Business or Economics
Futures contracts contribute to:
- Price discovery and market transparency
- Risk management and hedging efficiency
- Liquidity in financial and commodity markets
- Stability in supply chains and production planning
They play a critical role in global trade and financial market infrastructure.
Types or Variations
Commodity Futures: Agriculture, energy, metals.
Financial Futures: Interest rates, equity indices.
Currency Futures: Exchange-traded FX contracts.
Cash-Settled Futures: No physical delivery; settled in cash.
Related Terms
- Derivative
- Forward Contract
- Hedging
Sources and Further Reading
- U.S. Commodity Futures Trading Commission (CFTC)
- CME Group – Futures Education
- Intercontinental Exchange (ICE)
- Investopedia – Futures Contract
Quick Reference
- Standardized exchange-traded derivative.
- Used for hedging and speculation.
- Marked to market daily.
Frequently Asked Questions (FAQs)
Are futures contracts risky?
Yes. Leverage and price volatility can amplify gains and losses.
Do futures require physical delivery?
Many contracts are closed before expiration; some are cash-settled.
Who regulates futures markets?
In the U.S., futures are regulated by the CFTC.
