Futures contracts are legally binding agreements which two parties usually enter into on a futures exchange trading floor or electronic platform. They spell out the particulars for selling or buying specific financial instruments or commodities for a pre-set price at an exact moment in the future. Such contracts have become standardized to make it easy to trade them on the various futures exchanges. They provide information on the quantity and quality of the commodity, though this depends on the nature of the underlying asset.
Futures contracts can be settled in two ways. Some of them require actual physical delivery of the commodity specified. Others simply settle between the two parties in cash. These contracts specify all important characteristics for the item which the parties are trading. This makes them different from the word “futures” that more generally refers to the markets in which these commodities and instruments trade.
There are two actual types of participants in the futures markets who utilize such futures contracts. These are speculators and hedgers. Individual traders and managers of portfolios can use them to place speculative bets on the direction of price movements for the given asset that underlies the contracts. Hedgers involve buyers or producers of the contact asset itself attempting to lock in the price for which they will later buy or sell their commodity.
There are many different commodities and assets for which futures contracts exist. The most obvious of these are hard assets such as precious metals, industrial metals, natural gas, crude oil and other energy products, grains, seeds, livestock, oils, and carbon credits. Literally dozens of the more significant stock market indices around the globe have these contracts available to trade. Some major individual stocks have their own futures contract on their shares as well. The major interest rates and most important currency pairs also have such contracts and markets to trade.
Futures contracts which require physical delivery do not often result in such physical delivery. Many investors in these contracts trade them and sell them before the date of delivery. They can roll them forward by selling the imminent to expire contract and buying a further month out to replace them.
For producers of a good, these contracts provide a unique solution to the problem of fluctuating prices. Oil producers are classic examples. They might intend to produce a million barrels of oil to deliver in precisely a year. If the price is $50 for a barrel today, and the producer does not want to risk prices falling lower, it could lock it in. Oil prices have become so volatile that they could be substantially lower or higher a year from now. By selling a futures contract, the producer gives up the opportunity to possibly sell the oil for more in a year. It also eliminates the risk of receiving a lower amount.
Mathematical models actually determine the prices of futures contracts. They consider the present day spot price, time until maturity, risk free return rates, dividends, dividend yields, convenience yields, and storage costs. This might mean with oil prices at $50 that a one year futures contract sells for $53. The producer receives a guarantee for $53 million and will have to provide the 1 million barrels of oil on the exact delivery date. It will obtain this $53 per barrel price despite the spot prices at which the markets are trading on that date.