Futures contracts may seem like a complex financial instrument for those who haven’t studied finance. But in reality, futures contracts can be broken down into simple terms that even a novice can understand. In this article, we’ll take a look at what futures contracts are, how they work, and why they are important for businesses and investors alike.
What is a Futures Contract?
A futures contract is a financial instrument that is traded on a futures exchange. It is an agreement between two parties to buy or sell a particular asset at a specific time in the future, at a predetermined price. The asset in question can be anything from crude oil and gold to corn and soybeans. Futures contracts are standardized agreements, which means they have a specific size, quality, quantity, and delivery date.
How Do Futures Contracts Work?
Let’s say that you are a farmer who grows corn. You want to ensure that you will be able to sell your corn at a certain price, so you enter into a futures contract with a buyer. The buyer agrees to buy a specific amount of corn from you at a specific time in the future, at a price that is agreed upon now. This protects you from fluctuations in the market price of corn.
On the other hand, the buyer of the futures contract is also protected from price volatility. Let’s say that you run a cereal company, and you need to buy a large amount of corn to make your cereal. You enter into a futures contract with a farmer, agreeing to buy a specific amount of corn at a specific price at a specific time in the future. This protects you from the risk of price fluctuations in the corn market, which could affect the cost of producing your cereal.
Why are Futures Contracts Important?
Futures contracts allow businesses and investors to manage risk in the future. Whether you are a farmer, a cereal company, a gold miner, or a crude oil producer, you can use futures contracts to lock in a price for your product or raw material. This protects you from price fluctuations in the market, which can be especially important if you’re dealing with commodities that are subject to volatile price swings.
Futures contracts are also important for speculators, who buy and sell futures contracts on the exchanges. Speculators are not interested in the underlying asset, but rather in making a profit on the price of the futures contract itself. This can lead to increased liquidity in the market, which benefits businesses and investors who need to trade futures contracts to hedge their risks.
In conclusion, futures contracts are a financial instrument that allows businesses and investors to manage risk in the future. They are agreements between two parties to buy or sell a specific asset at a specific price at a specific time in the future. Futures contracts are important for managing risk and ensuring stable prices in the market, and they are also a tool for speculators to trade on the exchanges.
