Futures are standardized forward contracts traded over an exchange. Forward contracts are derivatives which set the price for a commodity or asset exchanged in the future today. Forwards are typically customized over the counter vehicles, which have their expiration and unit size modified for the buyer or seller of the contract. Customized forward contracts typically last a long time, while futures are traded in standardized duration according to the exchange’s regulations.
Market versus Contract Price
Since goods are delivered in the future at a price agreed on today their current price can differ from their delivery price. This allows underlying asset traders to secure sales prices in advance. It also allows for profits or losses to occur. You suffer a loss if you agreed to pay more for an asset than its value at delivery. You create gains if you agreed to pay less for an asset than its value at delivery. No money is actually exchanged until the delivery date. If you want to exit the position, you must find another party to replace you in the contract as payer or deliverer, you can alternatively renegotiate the contract with your original counterparty or exchange.
Forwards and futures are primarily intended to hedge risks. Securing a price now ensures that future disasters don’t disrupt market prices for purchasers. Wars, droughts, labor strikes, hurricanes, and other instabilities destroy supply chains and raise prices. Purchasers of forwards and futures are hedging against risks and prices being equal or higher in the future. The seller believes these shocks won’t occur and expects the price to be equal or lower in the future. Shocks usually have echoing impacts across markets. Any shortage or price increase in any underlying commodity brings price increases in all products developed from that commodity. Advanced purchasing of commodities via futures helps alleviate supply chain issues. Commodities markets help determine the value of goods, but cannot preserve rises or protect from falls in value. Futures help alleviate these concerns.
Underlying Asset Categories
Futures contracts divide into three general underlying asset categories: commodities, currencies, and financials. Commodities are bulk physical assets. Currency futures are based on monetary denominations of various nations, and the trade which connects them. Financial futures are based on underlying assets trading in the marketplace. Futures contracts secure prices for each category before delivery. Contracts also secure the quality of an asset to be delivered, if there are discernible quality differences between one underlying asset and another. Physical contracts are often defined in grades, such as differing strains of goods or differing production qualities.
Contracts also define terms of delivery. If the asset is a physical asset, a contract trader can specify if they want the underlying asset itself delivered or the money behind the trade. The physical asset may have a specific place of delivery stated, or be stored in a warehouse for retrieval by the receiver. Winning traders often sell off their future before maturity instead of receiving their settlement. Financial Futures usually have the money backing the trade delivered, but may have financial assets transferred. Index futures, a subset of financial futures, are universally cash settlement.
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