What Is A Futures Contract?

When working in any industry, there are certain industry sprecific terminology that one needs to familiarize themselves with. In finance, a futures contract is one such term which often raises questions.

If you are asking yourself ‘What is a futures contract?‘ then you are at the right place. We will try to answer your question to the best of our ability.

In trading, especially one which involves exchange of any kind of assets, contracts are absolutely imperative. A contract ensures that both parties are legally obligated to keep their part of the deal.

A futures contract is however a little different from a regular contract. Let’s find out how.

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What is a Futures Contract? : A Simplified Explanation

A futures contract can be defined as a binding legal agreement, to buy or sell a particular asset or commodity at a previously agreed upon price, during a specified time in the future.

These contracts are mainly used to facilitate trading on a futures exchange. They are standardized for quality and quantity.

When the buyer signs a futures contract, it means that he/she is taking on the obligation to buy the underlying asset when the futures contract expires, while the seller of the futures contract is now obliged to provide the underlying asset at the expiration date.

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Functioning Of Futures Contracts

“Futures contract” and “futures” are essentially the same thing, and they are used by two wide categories of market participants: hedgers and speculators.

Hedgers are the producers or the purchasers that guarantee the price at which the commodity is sold, while speculators refer to the traders who may also speculate and bet on the price movements of an underlying asset using futures.

Futures contract can be used by any party that wants to either buy or sell a particular commodity, at a specifed time in the future.

These contracts are available on assets like stock exchange indexes, commodities, and currencies.

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Why Use a Futures Contract?

A futures contract can help the involved parties bypass any market volatility that might exist. Here’s an example to illustrate the above.

Let’s say a real estate agent wants to sell a house for a $100,000 dollars. If he feels that the house could fetch a higher price in a month, then he might not opt for a futures contract.

However, if he feels this is the best price he could get for the house, then he may choose to lock the price with the buyer and sell it after a month. In that case, both parties will sign a futures contract.

Usually a mathematical model is used to determine the price of futures, which calculates the current spot price, the risk-free rate of return, time to maturity, storage costs, dividends, dividend yields, and convenience yields.

These contracts are all standardized.

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