What Is a Futures Contract?
How Futures Contracts Set Prices of Things You Buy Everyday
A futures contract is an agreement to either buy or sell an asset on a publicly-traded exchange. The asset is a commodity, stock, bond, or currency. The contract specifies when the seller will deliver the asset. It also sets the price. Some contacts allow a cash settlement instead of delivery.
Future contracts are traded on a commodities futures exchange. These include the Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange. These are all now owned by the CME Group. The Commodities Futures Trading Commission regulates them. Buyers and sellers must register with the CFTC.
The role of the exchange is important in providing a safer trade. The contracts go through the exchange's clearing house. Technically, the clearing house buys and sells all contracts.
The exchanges make contracts easier to buy and sell by making them fungible. That means they are interchangeable. But they must be for the same commodity, quantity, and quality. They must also be for the same delivery month and location. Fungibility allows the buyers to "offset" contracts. That's when they buy and then subsequently sell the contracts. It allows them to pay off or extinguish the contract before the agreed-upon date. For that reason, futures contracts are derivatives.
How Futures Contracts Affect the Economy
Companies use futures contracts to lock in a guaranteed price for raw materials such as oil. Farmers use them to lock in a sales price for their livestock or grain. Futures contracts guarantee they can buy or sell the good at a fixed price. They plan to transfer possession of the good under contract. The agreement also allows them to know the revenue or costs involved. For them, the contracts reduce a significant amount of risk.
Hedge funds use futures contracts to gain more leverage in the commodities market. They have no intention of transferring any commodity. Instead, they plan to buy an offsetting contract at a price that will make them money. In a way, they are betting on the future price of that commodity. Price assessment and price forecasts for raw materials are how commodities futures affect the economy. Traders and analysts determine these values.
Types of Futures Contracts
Commodities - The most important is the oil futures contract. That's because they set current and future oil prices. Those are the basis for all gasoline prices. Other energy-related futures contracts are written on natural gas, heating oil, and RBOB gasoline. Crude oil prices affect gasoline prices directly because 71 percent of the gasoline price is dependent on the price of crude. A rise in crude oil prices will raise the pump price as well.
Commodities contracts are also written on metals, agricultural products, and livestock. They are also written on financials such as currencies, interest rates, and stock indices. Investing in commodities futures is risky because prices are volatile and fraudulence is prevalent. Investors have to know the market very well or they risk losing their investment, quickly.
Forward Contract - The forward contract is a more personalized form of a futures contract. That's because the delivery time and amount are customized to address the particular needs of the buyer and seller. In some forward contracts, the two may agree to wait and settle the price when the good is delivered. A forward contract is a cash transaction. It is common in many industries, especially commodities.
Futures Option - A futures option gives the purchaser the right, or option, to buy or sell a futures contract. It specifies both the date and the price. Contracts on options are commonly set for a month or more. Weekly contracts are becoming popular for those who like to wager on short-term events.
Forward Rate Agreement - A forward rate agreement is an over-the-counter forward contract. It is written on a short-term interest rate. The buyer of an FRA is a notional borrower. That means the buyer commits to pay a fixed rate of interest on some amount that is never actually exchanged. The seller of an FRA agrees notionally to lend a sum of money to a borrower. Investors use FRAs to hedge interest rate risk or to speculate on future changes in interest rates.