Futures Contract: Definition, Uses and Risk Management

A Futures Contract is a legally binding AGREEMENT between two parties to buy or sell a specific asset or commodity at a predetermined price and date in the future. They are TRADED on an exchange, and provide an efficient way for producers and consumers to Manage the Risks associated with price fluctuations.

Futures Contract – What It Is?

They being DESIGNED to provide a transparent, efficient, and standardized way to trade commodities.

A futures-contract as per IFRS 9 Derivatives typically INCLUDES the following elements:

  • The underlying asset or commodity being traded (e.g., crude oil, gold, wheat);
  • The delivery date when the contract expires;
  • The delivery location (if applicable);
  • The contract size, which specifies how much of the underlying asset is being traded;
  • The tick size, which is the smallest price increment at which the contract can be traded; AND
  • The contract value, which is the product of the contract size and the current market price of the underlying asset.
futures contract

Futures Contract – Types of Use

They are used by a variety of MARKET participants, including producers, consumers, and speculators.

Producers use futures-contracts to lock in prices for their products, which helps them plan their production and manage their cash flows.
e.g, a Wheat Farmer may Sell a futures-contract for the wheat they plan to harvest in six months. By doing so, they can GUARANTEE a price for their crop, even if the market price drops in the meantime.
Consumers use futures-contracts to secure a steady supply of raw materials at a fixed price. e.g, an Airline may Purchase a futures-contract for jet fuel to ensure that they have enough fuel to OPERATE their planes, regardless of price fluctuations.
Speculators are traders who are not interested in the underlying asset but are instead trying to profit from price movements. Speculators use futures contracts to make bets on the direction of prices.
e.g, a Trader may Buy a futures-contract for gold if they believe that the price of gold will increase in the future.

Futures Contract As a Risk Management Tool

They are a highly LEVERAGED instrument, which means that traders can control a large amount of the underlying asset with a relatively small amount of capital. This makes futures contracts a popular choice for traders who want to make large bets on price movements.

However, leverage also increases the risk of losses, which is why it is important for traders to UNDERSTAND the risks involved before trading futures.

The Bottom Line

Futures Contract a powerful tool for managing risk and making bets on price movements. It provide a TRANSPARENT and STANDARDIZED way to trade commodities, and they are used by a variety of market participants.

However, trading futures can be risky, and it is important for traders to have a deep understanding of the underlying asset and the risks involved.

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