What is a Futures Contract? A Simple Definition
Both futures and forward contracts are financial tools that allow traders to offset or take on the risk of a price change of an asset over a given amount of time. But there are two important ways in which futures contracts differ from forward contracts:
- A legally binding futures contract allows the participant to buy or sell a standardized asset on a specific date, or during a specific month. This product can be a financial asset (eg the U.S.D. value of 1million Euro in August), or agricultural; say 10,000 bales of straw to be delivered in March. It’s an easy way for buyers and sellers to transfer contracts when trading.
- The purchase of the standardized asset is carried out via a futures exchange. Having standardized contracts makes them indispensible to commodities consumers, traders, producers and investors, as there’s quality and quantity assurance, for all participants and exchange-traded, which eliminates counter-party risk. As the futures contracts are standardized, the only variable is price, which is established through ‘quoting’ (bidding and offering) until a match (trade) results.
Exchange-traded futures contracts…
• Are centrally cleared, meaning that when a contract is bought or sold, the exchange becomes the seller to every buyer and the buyer to every seller. This eliminates counterparty risk and, unlike a forward contract, provides anonymity to futures market participants.
• Specify the quality, quantity, and physical delivery time and location for the given product, and it’s identical for ALL participants. The exchange also guarantees the contract will be honoured.
Bringing confident buyers and sellers together on one platform enables buyers and sellers to easily enter and exit the market, making futures markets optimal for price discovery, as well as highly liquid.