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 prices. All information about Futures.