Futures

A Future contract is a type of standardized derivative contract made between two parties through an organized exchange to buy or sell an underlying asset on a future date at an agreed-upon price. Both the parties engaged in the contract, are obligated to perform the trade on the specified date. The payoffs for futures are similar to that of forwards however, there is no credit risk of the opposite party, as the exchange clearing house clears all the trades. To mitigate risk, exchanges demand a margin payment at the time a trader enters into a contract which is further maintained on a mark to market basis.

Futures are generally used to hedge the risk of price fluctuations by fixing the price in advance. Speculators also use futures to make a profit through analyzing and forecasting the future price movements.

Example

Futures of grade A rice are being traded on a commodities exchange and each contract is for 100 kgs. Neil wants to buy 5,000 kgs of grade A rice during the last week of the month while  Russell seeks to sell 5,000 kgs of grade A rice during the last week of the month. The futures contract is suitable for the both parties,  as a trade could be executed between the two parties for 50 contracts on the exchange. The disadvantage of the futures is that the contracts are not customized as in forwards. For example, if both the parties in the above example wanted to trade 4000 kgs then the futures contract would not have served their purpose.