What is Futures Contract?
Forward Contract and Future Contract forms are considered the two most essential products for Hedging. They are also called linear derivatives as they follow a zero-sum game, i.e. profit of party A is the loss of party B.
As opposed to a forward contract, a futures contract is more formal with the involvement of an exchange. The contract is a legally binding agreement to buy or sell the underlying assets in a predesignated month in the future at a price agreed upon today by the buyer/seller. Futures are more used for commodity hedging.
Futures contracts are standardised with predefined quality, quantity, delivery time, and location for each specific commodity.
Example of Forward Contract:
Future contracts are often used in the commodity market. Let's take an example of a cereal producer. The cereal producer takes a long position in corn, and party B is corn farmers taking a short position in corn. One party takes a long position, agreeing to purchase the corn at a future date for a specified price, while the other party is short, agreeing to sell the corn on that same date for that same price.
Why is a Future Contract important?
Future contracts are considered one of the most widely used hedging products, especially in the commodity market. Hence, risk managers must understand the forward contract well.