A futures contract is a type of
derivative which allows an
underlying instrument to be either
bought or
sold at a
future date in time, at a predetermined
price.
The date is known when the contract is entered into, and is called the
maturity date of the future.
Various
characteristics of the underlying instrument are also specified by the futures contract; these depend largely on the
underlying instrument
For example, an
oil futures contract will specify in addition to the number of
barrels of oil, a
grade; that is, the amount of
sulphur the oil may contain.
Commodity futures will specify a delivery
place - where the underlying instrument (e.g.,
pigs) are to be delivered when the contract matures.
The purchaser of a futures contract is allowed to
acquire the underlying instrument at the predetermined price.
The seller of a futures contract is obliged to
purchase the instrument, again at the predetermined price.
One enters into a futures contract by placing an initial
amount of
cash, known as
margin with a
broker. As the underlying instrument changes in value on a daily basis, the futures contract is
marked to market; that is, priced to reflect the
market value of the underlying instrument.
This process of pricing futures contracts to their market value on a daily basis is known as
variation margin.
Futures contracts are inherently
risky for speculation due to variation margin.
As hedging vehicles futures as essential for commodity producers as they allow prices to effectively be locked in.