Legal Definitions - futures contract

A futures contract is a standardized legal agreement between two parties to buy or sell a specific asset at a predetermined price on a specific date in the future. These contracts are traded on exchanges and are designed with uniform terms regarding the quantity, quality, and delivery specifications of the underlying asset. Futures contracts are primarily used for two main purposes: to manage financial risk by locking in prices (known as "hedging") or to speculate on the future price movements of various assets, including commodities, currencies, and financial instruments.

Here are some examples to illustrate how futures contracts work:

• Protecting a Coffee Harvest: Imagine a large coffee plantation owner in Colombia who anticipates harvesting their crop in eight months. They are concerned that the global price of coffee might drop significantly by then, potentially reducing their expected income. To mitigate this risk, the owner could enter into a futures contract today to sell a specific quantity of their future coffee harvest at a fixed price, for example, $1.80 per pound, for delivery in eight months. This contract guarantees the owner a specific selling price, regardless of what the market price for coffee is when the harvest is ready. The buyer, perhaps a large coffee distributor, benefits by locking in their purchase price, protecting them from potential price increases.

• Managing a Shipping Company's Fuel Costs: A major international shipping company relies heavily on bunker fuel to power its vast fleet of cargo ships. The price of this fuel can be highly volatile, making it challenging for the company to forecast and manage its operational expenses. To stabilize their costs, the shipping company's procurement department might enter into futures contracts to purchase a certain volume of bunker fuel at a set price for delivery six months in the future. By doing so, they lock in a predictable cost for a significant portion of their future fuel needs, shielding them from sudden spikes in oil prices that could severely impact their profitability and freight rates.

• Speculating on Currency Exchange Rates: An investor believes that the Japanese Yen will significantly strengthen against the US Dollar over the next four months due to anticipated economic policy changes. Instead of directly exchanging a large sum of money, which might be inconvenient or require significant upfront capital, the investor could purchase a Yen futures contract. This contract obligates them to buy a specific amount of Japanese Yen at a US Dollar price agreed upon today, for settlement in four months. If the Yen does strengthen as predicted, the investor can sell their futures contract at a higher price before the delivery date, making a profit from the favorable exchange rate movement without ever having to physically exchange currencies.