As the name suggests, futures contract definitely has to do something with the future! A futures contract can be explained by the following point-
- It is a contract between two parties for the purchase or sale of a specified asset or commodity of a standardized quantity and consistent quality;
- With the delivery of the asset and payment in return to occur on a certain future date but for a price which is agreed upon today.
- The one agreeing to buy the asset specified in the future is the ‘buyer’ of the contract;
- The one agreeing to sell the asset specified in the future is the ‘seller’ of the contract;
- The exchange is an authorised one since it takes place through the ‘futures exchange’.
- Futures exchange is an institute which authorizes a futures contract and acts as an intermediary between the buyer and the seller of the contract so as to strike a deal on the price and the date involved in the contract.
But now there must be doubt- Will either of the parties not bear the risk on predetermining the price since the prices of the asset would keep on fluctuating? Well the answer to it is Yes (but to a certain extent) and No. The reason for No is that there is a process called ‘marking to market’ to overcome this problem. In marking to market, the exchange requires that both the parties put up an initial amount of cash with it as the margin. When due to regular fluctuations in the market, there would be a chance of one party suffering due to it, then the same amount is transferred from the other’s party account to it. Hence this helps in prevention of the risk involved. Hence on the delivery date, the amount to be exchanged would not be the specified price in the contract, but it would be the spot value, since any gain or loss would have been previously settled by marking to market.