What is a futures contract?

A futures contract is a legal agreement to buy or sell a specific commodity, asset, or security at a predetermined price at a future date. These contracts are standardised for quality and quantity, facilitating trading on a futures exchange. The buyer commits to purchasing the asset upon expiration, while the seller agrees to deliver it.

Features of a futures contract

1. Standardised agreement: Futures contracts have standardized terms, including the quantity, quality, and delivery date of the underlying asset.
2. Exchange-traded: They are traded on organized exchanges, providing liquidity and transparency.
3. Margin requirements: Traders must deposit an initial margin and maintain a maintenance margin, which acts as collateral.
4. Leverage: Futures offer significant leverage, allowing traders to control a larger asset position with a relatively small amount of capital.
5. Price transparency: Real-time price information is readily available, ensuring fair market pricing.
6. Mark-to-market: Positions are settled daily, with profits and losses realized daily.
7. Risk management: Often used for hedging against price fluctuations in the underlying asset.
8. Delivery or cash settlement: Depending on the contract, settlement can be physical delivery of the asset or cash settlement based on the price difference.
9. Expiration date: Futures contracts have a specified expiration date when the contract must be closed or rolled over to a new contract.
10. Diverse asset classes: Futures contracts are available on a wide range of underlying assets, including commodities, financial instruments, and stock market indices.

Futures contract example

Imagine you're a wheat farmer, and you're worried about the future price of wheat. You can enter into a futures contract to sell a specific quantity of wheat at a fixed price to a buyer, say, six months from now.

• If the price of wheat falls below the contract price when the contract expires, you benefit because you get to sell your wheat at a higher price.
• If the price of wheat rises above the contract price, you might lose potential profits since you're committed to selling at the lower contract price.

Advantages and risks associated with futures contract

Futures contracts offer several advantages to market participants, including:

1. Hedging: Futures contracts are widely used for hedging against price volatility. For example, a farmer can hedge against the risk of falling crop prices by selling futures contracts, ensuring a fixed price for their produce.
2. Liquidity: Futures markets are highly liquid, with a significant number of participants. This liquidity allows for easy entry and exit, minimizing the risk of being unable to buy or sell a contract.
3. Portfolio diversification: Futures contracts provide an opportunity to diversify investment portfolios by gaining exposure to various asset classes, including commodities, currencies, and stock market indices.
4. Efficiency: Futures markets are often more cost-effective than physical trading. This is because they involve lower transaction costs, such as storage, transportation, and handling fees.
5. Regulated environment: Futures markets are subject to regulatory oversight, ensuring fair trading practices, transparency, and market integrity.

Risks associated with futures contract

Futures contracts offer opportunities for profit, but they also carry inherent risks that traders and investors should be aware of. Here are some of the key risks associated with futures contracts, along with brief explanations:

1. Margin call risk: If the market moves against your position, you may be required to deposit additional margin to cover potential losses. Failure to meet margin calls can lead to forced liquidation of your position.
2. Expiration risk: Futures contracts have fixed expiration dates. If you don't close or roll over your position before expiry, you may face delivery obligations or cash settlement at an unfavourable price.
3. Interest rate risk: Interest rate futures are sensitive to changes in interest rates. Movements in rates can affect the profitability of your position.
4. Systemic risk: Futures markets are interconnected with other financial markets. Events affecting broader financial markets can spill over into futures markets, affecting your positions.
5. Delivery risk: For physically settled futures contracts, there's a risk of encountering issues related to the delivery of the underlying asset, such as quality or logistical problems.
6. Global events risk: International events, such as political developments, natural disasters, or economic crises, can impact commodity and currency futures.
   
   Understanding and managing these risks is crucial for anyone involved in futures trading. Risk management strategies, including the use of stop-loss orders, diversification, and thorough research, can help mitigate potential losses and enhance the chances of successful futures trading.

Futures contract vs. Forward contract

Forward contracts and futures contracts differ significantly:

• Forward contracts are private, customizable agreements traded OTC, while futures contracts are standardized, exchange-traded contracts.
• Forward contracts have higher counterparty risk, while futures contracts use exchange clearinghouses to mitigate this risk.
• Liquidity is generally higher in futures markets due to their exchange-traded nature, whereas forward markets may lack liquidity for certain contracts.

The choice between forward and futures contracts depends on an individual or entity's specific risk management needs, customization requirements, and risk tolerance.

Conclusion

In conclusion, futures contracts play a crucial role in the world of finance, offering a means of managing risk and facilitating price discovery across various asset classes. These standardized agreements, traded on organized exchanges, provide participants with a transparent and regulated platform. While futures contracts offer numerous advantages, including leverage and liquidity, they also come with inherent risks, such as price volatility and margin calls. Therefore, individuals and businesses looking to engage in futures trading should approach it with a well-defined strategy, thorough research, and a clear understanding of both the opportunities and challenges presented by this powerful financial tool.