Definition of Futures Contract

A futures contract is a legal agreement based on future exchanges, that is, buying and selling of a financial instrument in both equity and commodity at a fixed price in the future at a specified time.

Points to remember:

• There are two categories of people dealing with Futures contracts: Hedgers and Speculators.
• Futures contracts can either call for physical deliveries of the commodity or are settled with cash.
• A Futures contract is usually chosen to avoid extreme changes in price levels in the market whilst gaining risk free returns.

Example:

Let us assume that you are interested in purchasing stock X which is priced at Rs. 100 today. You enter a futures contract to buy Stock X at a later date that is two days from now. Thus, you enter into a promissory agreement with the exchange to pay Rs. 100 two days from now. Now, even if the market price of Stock X increases to Rs. 150 or Rs. 200 on the day of the payment--you still pay the previously promised Rs. 100--irrespective of the market price of Stock X at that moment.