Futures are among the most common derivatives and play a crucial role in financial markets. They help reference pricing expectations for products as varied as commodities, stocks and interest rates. They can also be used in the procurement of raw materials and to hedge against market volatility.
As opposed to spot markets, where the price you pay for a product is the current price for immediate delivery, a futures contract is an agreement to buy a product at a future date at an already specified price.
Many companies that rely heavily on fuel and materials, such as metals that are sold on commodity exchanges (and therefore subject to speculative price swings), buy futures contracts to help smooth volatility – as the price for delivery in 12 months might be cheaper than the current spot price.
But other, non-physical assets can be traded as futures too. Among the most popular are stock index futures and interest rate futures, which are generally used by portfolio managers as a hedging strategy.
Let’s say you’re the procurement officer at Alpha Aluminium, a maker of cast aluminium products. You buy most of your metal on the spot market, but due to seasonal factors there are more orders for your company’s products in the second half of the year.
You’re currently buying at $1,700 a tonne on the spot market, but the futures market indicates you could buy at $1,600 a tonne five months from now. As long as the spot price remains above $1,600 in five months’ time, you’ve saved your company money.
You, if you get it right. If, in five months’ time when the futures contract expires, the spot price is still $1,700 a tonne, the writer of the contract owes you $1,000 per tonne. The danger is always that you’ll end up on the wrong side of the bet. If, in five months’ time, the spot price has fallen to $1,500 a tonne, you owe the writer of the contract $1,000 per tonne.