Before knowing the Types of Future Contracts; we must understand what a future contract actually is.
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future.
Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.
The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires.
The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.
Key Features:
A futures contract is a legal agreement that binds a buyer and a seller to trade specific assets at a predetermined price and date in the future.
There are four common types: currency, stock market index, commodity, and interest rate futures.
It is used for speculative and hedging purposes since it helps to lock in a specific price.
Forwards are different because forwards are non-standardized and traded over the counter, unlike futures that are standardized and traded through exchanges.
Understanding Futures Contract
A futures contract is a derivatives contract obligating the buyer and the seller to transact the underlying asset at a pre-determined future date and price irrespective of market price at the expiration date.
The buyer should buy and receive the underlying asset when the futures contract expires. The seller should deliver the underlying asset at the expiration date.
Furthermore, it has a standard size. For example, the standard contract size for gold futures is 100 ounces.
Speculators and hedgers primarily use it. Using futures, speculators risk by betting on a future price, while hedgers try to reduce the risk by locking in a price.
Furthermore, if the price of the underlying asset decreases, the seller is holding a short position then the seller benefits from the price drop.
If the price of the underlying asset increases, then the buyer taking a long position can obtain the profit.
Types of Future Contracts
Commodity Futures
It stipulates the commodity‘s price time and volume in the contract for both parties. The contract is generally cash settled.
The three basic components of commodity futures are metal, food, and energy. For example, it can be gold, silver, crude oil, etc.
For commodities, it is essential because it reduces the risk faced by the buyers due to the probability of prices increasing in the future.
Such contracts are sold on exchanges ensuring a safer trade. Companies use futures contracts to obtain a fixed price for commodities they buy from commodity producers.
Currency Futures
In these contracts, the underlying assets are currency exchange rate; the rate defines the exchange between any two currencies, for example, the US Dollar to the Euro exchange rate, the Indian Rupee to the English Pound rate, or the English Pound to the US Dollar rate. In essence, it is the contract to exchange one currency for the other.
The currency futures remain constant as in all other futures and are traded similarly. Such currencies are traded via currency brokers in exchanges like Chicago Mercantile Exchange.
Interest Rate Futures
These contracts concern interest-bearing financial instruments or debt instruments. They are used for hedging and speculative purposes.
An example of an underlying instrument is treasury bills and treasury bonds. These futures are settled either way by cash or by physical delivery.
Stock Market Index Futures
These contracts are in context to the stock index, so the underlying asset is linked to a stock index.
Future brokers trade these primarily for hedging, spread trading, speculating, etc. It is also a part of technical indicators denoting market emotion and sentiment.
Example
Let’s understand it with a simple futures contract example:
Luther started a company that consistently requires silver, and his company is already in conversation with a company supplying silver.
The silver provider uses a futures contract to bind Luther and his company, promising to sell a fixed quantity of silver at a pre-determined price and the time the delivery will be executed.
Luther agrees to the contract. Now both of them are obligated to trade the silver in the future at a set price
contract. Now both of them are obligated to trade the silver in the future at a set price.
Futures Contract vs. Forward Contract
A futures contract is similar to a forwards contract, where a buyer and seller agree to set a price and quantity of a product for delivery at a later date. Both types of contracts can be used for speculation, as well as hedging.
However, there are also important differences. While a futures contract is a standardized agreement that can be traded on an exchange, a forward contract is simply a private agreement between a buyer and a seller.
While it is possible to trade forwards on OTC markets, they are less regulated and less accessible to retail investors.
This means that there are also more opportunities to customize a forward agreement according to the buyer’s and seller’s needs.
Related: Difference between forward contract and futures contract
Why Is It Called a Futures Contract?
A futures contract gets its name from the fact that the buyer and seller of the contract are agreeing to a price today for some asset or security that is to be delivered in the future.
Are Futures and Forwards the Same Thing?
These two types of derivatives contract function in much the same way, but the main difference is that futures are exchange-traded and have standardized contract specifications.
These exchanges are highly regulated and provide transparent contract and pricing data. Forwards, in contrast, trade over the counter (OTC) with terms and contract specifications customized by the two parties involved.
Who Uses Futures Contracts?
Speculators can use futures contracts to bet on the future price of some asset or security.
Hedgers use futures to lock in a price today to reduce market uncertainty between now and the time that good is to be delivered or received.
Arbitrageurs trade futures contracts in or across related markets, taking advantage of theoretical mispricings that may exist temporarily.
Conclusion
In finance, futures are a type of financial contract obligating the buyer to purchase an asset or the seller to sell an asset, such as a physical commodity or a financial instrument, at a predetermined future date and price.
There are many different types of futures. They can be categorized according to the type of asset being traded, when the asset can be delivered when the asset contract can be traded, and whether the contract is standardized or customized.
