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Future Contract Definition

The term “future contract” may sound like something out of a sci-fi movie, but it is actually a common financial instrument used by investors to manage risk. A future contract is a legally binding agreement between two parties to buy or sell an underlying asset at a specific price and date in the future.

The underlying asset can be anything from commodities like oil and gold, to financial instruments like stocks and currencies. The future contract allows investors to lock in a price for the underlying asset, which can be beneficial in uncertain markets.

For example, let`s say a farmer wants to sell his crop of wheat, but he`s worried the price will drop by the time he harvests it. He can enter into a future contract with a buyer, agreeing to sell his wheat at a specific price on a specific date in the future. This allows him to lock in a price for his crop, giving him some certainty and protecting him against market volatility.

Future contracts are traded on exchanges, which act as intermediaries between buyers and sellers. The exchanges ensure that both parties fulfill their obligations under the contract, and they provide a platform for price discovery.

There are two main types of future contracts: commodity contracts and financial contracts. Commodity contracts are used for physical commodities like oil, gold, and agricultural products. Financial contracts, on the other hand, are used for financial instruments like stock indexes, currencies, and bonds.

One of the advantages of future contracts is that they can be used to hedge against risk. For example, an airline might enter into a future contract to buy fuel at a specific price in the future, to protect against rising fuel prices. By locking in a price for fuel, the airline can better manage its costs and mitigate the impact of price fluctuations.

However, future contracts also carry risks. If the price of the underlying asset drops significantly, the investor may be forced to buy the asset at a higher price than the market value. This can result in significant losses.

In conclusion, future contracts are a powerful tool for managing risk in financial markets. They allow investors to lock in prices for underlying assets, which can be beneficial in uncertain markets. However, investors should be aware of the risks involved and use future contracts as part of a broader risk management strategy.