Futures contracts

Futures contracts

Futures contracts is contract between two parties to exchange a commodity, currencies, securities, stock indexes, interest rates or financial instruments of specific amount for a mutually agreed price with the delivery only occurring at a later date. This contract requires both parties to provide a set amount of cash upfront and reduces the risk of default by either side.

The party that is going to buy the asset in the future, the buyer of the contract, is said to be long. The party agreeing to sell the asset in the future, the seller of the contract, is said to be short. This depicts what the separate parties expects from the contract. The buyer is hoping that the asset price will increase and the seller hopes that it will decrease.

The futures exchange has the purpose to act as intermediary and minimize the risk of default by either party. Thus the exchange requires both parties to pay an upfront initial cash amount called a margin. Seeing that prices range from day to day the agreed price will also vary daily. This difference is then transferred from the one party's margin account to the others for the daily profit or loss. When the margin account runs into a negative amount the account holder has to replenish the account. This process is know as marking to market. Therefore on the agreed delivery date the amount exchanged will not be the specified price on the contract but the spot value as the difference has already been settled by marking to market.