Definition of Futures Contract
A futures contract is a legally binding agreement between two parties to buy or sell a commodity or financial instrument at a designated time in the future (normally specifying the quantity, quality, delivery time and location of the underlying assets) for a pre-determined price. A future is part of a class of securities called derivatives, so named because such securities derive their value from the worth of an underlying investment. The buyer of the contract is said to be "long", and the seller is said to be "short" and were originally used to hedge risk in the agricultural commodities sector. Although now these contracts also cover other commodities, such as metals and hydrocarbons products, and are often used for purely speculative purposes. A straightforward example of futures being used to hedge risk would be if a large-scale food operation needs to secure wheat for the manufacture of its breakfast cereals. This company could simply just buy wheat in the spot wheat market (the deal being physically settled two days after the trade date) on an ongoing basis day after day. However, this would expose the company to the ever-changing prices of the wheat market, meaning that it could end up paying sustained higher prices in a long-term bullish wheat market, resulting in the firm having to rise the price of its breakfast cereals, with the adjunct possibility of it losing market share to its competitors. Instead, the firm could hedge its risk by purchasing the required amounts of wheat required at a series of points in the future for a specific price that has been locked into the futures contract. This arrangement hedges out the risk of prices going up, guarantees all future supplies, and allows the company to accurately predict and manage its cash flows going forward. Speculative futures contracts, meanwhile, see the usual dynamics of the market in play, in that if a seller shorts a contract and it goes down then makes a profit but if it goes up makes a loss, and vice-versa for a buyer of a futures contract.
