Futures contract

What it means

A futures contract is a standardised exchange-traded contract to buy or sell a commodity, currency or index in the future at a price agreed today. It is a type of derivative traded on commodity and financial exchanges with precisely specified quantity, quality and date.

Unlike a forward, which is a bespoke agreement with a bank, a futures contract trades on an exchange and a clearing house guarantees performance. Gains and losses are settled daily at the current price, and the trader must maintain collateral on the account, known as margin.

Futures are used for both hedging and speculation. A manufacturer needing copper can lock in a price for coming months, and a farmer can fix the selling price of grain. Speculators, by contrast, use leverage, controlling a large position with a small amount of margin.

How it works in practice

Most futures are not settled by physical delivery but closed out before expiry. A company hedging a raw material price buys futures and purchases the material from its supplier as usual, with the gain or loss on the futures offsetting the change in market price.

Daily settlement may require topping up margin when the price moves against the position. The company therefore needs spare liquidity, or the position may be forcibly closed at the worst moment even though the hedge would have worked in the long run.

In the accounts, derivatives are measured at fair value, with changes recognised in profit or loss or, under hedge accounting, in equity. For simplicity, small companies often choose a forward or an option from their bank instead of futures.

What to watch out for

Leverage magnifies losses as well as gains. Without experience and clear risk management rules, speculating with futures can cause losses exceeding the capital invested, so companies should use futures only to hedge a genuine risk.

Standardised contracts may not match the company's needs exactly in quality, quantity or date. The remaining mismatch, known as basis risk, can mean the hedge does not fully offset the change in the price the company pays its supplier.