The underlying asset of a futures contract can be a
wide variety of financial instruments
and commodities, such as stock indices,
bonds, currencies, raw or primary
products, etc.
The characteristics of futures are very similar to
those of options, but one crucial
difference between the two is that
options give the buyer the right to buy
the underlying asset, whereas futures
give the obligation to the buyer to buy
the underlying asset on the expiration
date. This means that both the buyer and
the seller of the futures contract must
fulfill the terms of the contract on the
expiration date.
The fulfillment of the terms of a futures contract is
possible in one of two ways, depending
on the type of the futures contract:
- Physical delivery – the specified quantity of the
underlying asset is delivered by the
seller of the futures contract to the
futures exchange. The exchange in turn
delivers the asset to the buyer of the
futures contract. This type of delivery
method is mostly used by parties
interested in the actual underlying
asset – usually the producers and
consumers of the underlying commodity.
- Cash settlement – a cash payment is made by the party
that sustained a loss on the expiration
date of the futures contract to the
party that profited. The amount paid is
calculated with the help of a rate that
is independent of the two parties, known
as a reference rate. The reference rate
is based on a specific index stated in
the terms of the futures contract, for
example a stock market index or the
Euribor (Euro Interbank Offered Rate of
interest rates). This method of
settlement is the most popular of the
two and is usually used by speculators.
There are two types of groups that actively trade in
futures contracts. They are traders (or
speculators) looking make a profit based
on the difference between the buying and
the selling price, with no intention of
actually owning the underlying asset,
and by non traders (also known as
hedgers) who have a vested interest in
an underlying commodity.
These non traders are usually the producers and
consumers of the underlying commodity
and are looking to hedge out the risk of
price changes of the commodity in
question. An example of this would be a
grain farmer looking to secure a sell
price for his future harvest, to do this
he would then sell a futures contract. A
livestock farmer would in contrast be
interested in buying a futures contract
to secure a buy price for his winter
feed, making it easier for him to plan
by taking the uncertainty of the future
price of feed out of the equation.
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Subjects keywords:
Futures,
Definition of futures,
Futures contracts, Commodity
futures,
Futures trades,
Futures exchanges,
Futures
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