Introduction to Financial Derivatives - Futures Contracts

To quickly reiterate, there are the following four basic derivatives:

- Forward contracts
- Futures contracts
- Swap contracts
- Option contracts

In this post we will look at futures contracts.

Futures Contracts
A futures contract is in essence a standardised forward contract executed in an exchange.

What this means is that again a futures contract is an agreement to buy something at a specified price on a specified future date. It is exactly the same principle as a forward contract. The only difference is that this contract is executed in an exchange and the terms of the agreement are set by the exchange.

A simple example:
A merchant knows that for the next year he will need wheat to produce flour. He predicts that wheat prices will go up during the year, so he decides to "lock" the current price. The merchant will order now bushels of wheat to be delivered at some future date for the current price. The merchant will enter into a futures contract (instead of a forward contract) where the terms of the contract (like the number of bushels of wheat, the price per bushel, the quality of the wheat, etc.) are standardised and set by the exchange.

* There are some other differences between the forward and futures contracts concerning risk which I will not mention here.