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What Is a Futures Contract?

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What Is a Futures Contract?

Traders set prices of food, gasoline and metals with futures contracts.

Photo: Spencer Platt / Getty Images
Definition: A futures contract is an agreement to either buy or sell an asset on a publicly-traded exchange. The asset is usually a commodity, a stock index or a currency. The contract specifies when it will be delivered and at what price. Most contracts specify that the asset must actually delivered, although some allow a cash settlement instead. Most contracts are paid off before the delivery date.

The role of the exchange is important in providing a safer trade. The contracts go through the exchange's clearing house, which technically buys and sells all contracts. The value is that you know it will be executed, instead of having to trust a trader on the trading floor or some anonymous electronic trading platform. Futures are traded on the Commodities Futures Exchange, which is regulated by the CFTC. Buyers and sellers must be registered with the

The exchange also makes contracts easier to trade, by making them fungible. This means that they are interchangeable -- as long as they're for the same commodity and delivery month, and have the same specifications for quality, quantity, delivery date, and delivery locations. The advantage of fungibility means that, if a contract is bought and then subsequently sold, it is considered "offset." This allows it to be extinguished without ever having to go to its agreed-upon date.

How Futures Contracts Affect the Economy

Futures contracts are often used by companies that want to lock in a certain price for oil, natural gas or other materials they need to operate. They are also used by farmers to lock in a sales price for their livestock or grain. For these businesses, futures contracts guarantee they will receive their supplies, or have a buyer for their product. They plan to actually transfer possession of the good under contract. The contract also allows them to know the revenue or costs involved. For them, the contracts reduce a great deal of risk.

More commonly, futures contracts are used by investors and even speculators purely to make a profit. They have no intention of transferring any commodity. Instead, they will purchase an offsetting contract at a price that will make them money. In a way, they are betting in the future price of that commodity.

Types of Futures Contracts

Commodities - The most important is the oil futures contract because they set current and future oil prices. This is the basis for all gasoline prices. Other energy-related futures contracts are written on natural gas, heating oil and RBOB gasoline. Commodities contracts are also written on metals, agricultural products, livestock, and financials such as currencies, interest rates and stock indices. For more, see Commodities Futures.

Forward Contract - This is a more personalized form of futures contract, in that the delivery time and amount are customized to meet the specific needs of the buyer and seller. In some forward contracts, the two may agree to wait and settle the price when the good is delivered. A forward contract is usually a cash transaction common in many industries, especially commodities. Futures Option - Instead of buying an actual futures contract, the option gives the purchaser the right, or option, to buy or sell the contract. It specifies both the date and the price. For more, see Options.

Forward Rate Agreement - This is an over-the-counter forward contract on a short-term interest rate. The buyer of a FRA is a notional borrower, i.e., the buyer commits to pay a fixed rate of interest on some notional amount that is never actually exchanged. The seller of a FRA agrees notionally to lend a sum of money to a borrower. FRAs can be used either to hedge interest rate risk or to speculate on future changes in interest rates. Article updated April 2, 2013

Examples:
Futures contracts are a derivative product typically used by hedge funds to gain more leverage in the commodities market.
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