Futures Contract Definition

What is a Futures Contract?

A futures contract is an agreement to buy or sell a standardised asset at a fixed price on a future date or during a specific month. Unlike forwards, futures are traded on a futures exchange, so they are more secure and standardised. This makes them useful for producers, consumers, traders and investors as they allow you to hedge against price changes. Because they are standardised and exchange traded, futures are key in financial markets.

Standardised Contract

An exchange traded futures contract specifies the quality, quantity, delivery time and location for the product. These can be:

• Agricultural commodities
• Financial assets

The specifications are the same for all. This makes it easy to transfer ownership through a trade. Only the price varies, determined by bidding and quoting until a match is found. Exchanges create these contracts so they are standardised.

Exchange Traded

The exchange guarantees every trade is honoured, so there is no counterparty risk. When you buy or sell a futures contract, the exchange is the buyer to every seller and the seller to every buyer. This centralised clearing makes the market more secure.

Benefits of Exchange Traded Futures:

• Less Credit Risk: The exchange removes the risk of one counterparty defaulting.
• Anonymity: Participants are anonymous, unlike in forward contract markets.
• Liquidity: Easy in and out, so easy to buy and sell.
• Price Discovery: The market is the best place to find fair prices because of the liquidity.

Futures Contract Details

Futures contracts are agreements to exchange a specific asset at a specific time in the future. These can be physical commodities like crude oil or financial products like foreign currencies. Each contract has the quantity, quality, delivery location and delivery date of the asset.

Underlying Asset:Physical commodities (e.g. crude oil, corn) or financial instruments (e.g. foreign currencies, Treasury bonds)

• Contract Size:Quantity of each futures contract
• Delivery Location:Where the asset is to be delivered. Important for physical commodities which have transportation costs.
• Delivery Date:Month and time frame the asset must be delivered. Contracts are often referred to by their delivery month e.g. “MarchWTI contract”

Delivery

For physical commodities, the exchange sets delivery standards to ensure quality.