What is a Futures Contract?
A futures contract may be an effective way to hedge against risk, especially if your business trades commodities. Read this article to find out more.
The term ‘futures contract’ refers to any legally binding agreement to buy or sell a particular commodity or asset at a later date in time. Two defining characteristics of a futures contract is that they:
- Specify the price of each item
- State the exact time and location in which the transaction will take place
The Difference Between Futures Contracts and Forward Contracts
It is important to not confuse a futures contract with a forward contract. Whilst futures contracts and forward contracts are both financial instruments pertaining to the future purchase of commodities and assets, there are a number of distinguishing features to be aware of.
Firstly, futures contracts are standardised whilst forward contracts are not. This means forward contracts are altered on a case-by-case basis given that they are negotiated behind the curtain of privacy. Thus, parties to futures contracts can buy or sell commodities at an acceptable quantity and quality.
Secondly, futures are traded through what is known as an ‘exchange clearing house’ whilst forward contracts are exchanged over-the-counter. The key benefit of a clearinghouse is that it acts as an intermediary. This means that it buys the commodity from the selling party and then sells the same commodity back to the buying party. This prevents losses that would otherwise arise from either party failing to fulfil the transaction on the specified date. In contrast, parties to a forward contract do not enjoy a similar elimination of counter-party risk.
The Legal Definition of a Futures Contract
- Eligible commodity agreement
- Adjustment agreement
- A futures option
- An eligible exchange-traded option
Why are Futures Contracts Important?
Businesses often use the futures market on the basis of various motivations. A significant motivation is to hedge against risk. This is especially so where the primary operations of the business involve the capitalisation of commodities.
For example, Boost Juice may want to hedge against the risk of price movements associated with strawberries. As such, it may want to enter into a futures contract to buy a particular amount of strawberries for a prescribed price in three months time. If the price increases in three months, Boost Juice will enjoy a discount. This is because it is paying less relative to the market. However, if the price decreases, Boost will incur a loss because it is now paying more than the market.
Futures contracts are a common way for businesses to obtain their commodities at a predetermined price, quality, quantity, time and location. The most obvious benefit of utilising this type of financial instrument is the fact that it is legally enforceable which, therefore, eliminates the risk of associating with unreliable vendors or customers. However, it certainly does not eliminate the risks associated with price movements. Therefore, it is important that you protect the financial health of your business by having a sophisticated understanding of market behaviour. A particularly important component of this area of knowledge is the correlation between commodities in terms of price.
If you have further questions or wish to seek advice on futures contracts, it is worth consulting a contracts lawyer.
Eric currently works in the content team as a legal intern for Lawpath. He is in his final year of a Bachelor of Commerce with a Degree in Bachelor of Laws (Majoring in Finance).