Futures or futures contracts are derivatives bought or sold on a futures exchange. Futures are contracts tobuy or sell a particular commodity at a specified price on a certain date in the future. The underlying asset could be commodities, energy, currencies, government bonds or other financial instruments. The future date on which the contract is executed is known as the final settlement date or the delivery date. The predetermined price is known as the settlement price. The mechanism for settlement is provided by the clearinghouse of the futures exchange.
Common Features of Futures
The common features of futures are:
Futures are exchange-traded derivatives.
Futures are highly standardized. This standardization is ensured by specifying (a)
The underlying asset – The particular asset as well as the quantity are specified in the futures contract.
The currency - The currency in which the contract is to be executed is also specified.
Settlement - The delivery month and the last trading date are also mentioned in the contract.
Futures are used for hedging, particularly in a bear market. Those who have an interest in the underlying asset can protect themselves from the risk of price changes via futures contracts.
Futures have lower transaction costs than other debt instruments.
They also have high liquidity, since buyers and sellers of futures contracts can be found easily.
Pricing of Futures
When the price of the underlying commodity in a futures contract is higher than the spot (immediate) price, the situation isknown as contango. When the price of the underlying commodity for future delivery is lower, the situation is known as backwardation.
The price of a futures contract can be calculated with the following formula
F(t) = future value
S(t) = present value
t = time
T = maturity
r = rate of return
Futures: Types of Settlement