What are futures contract?

Let’s talk about “futures contract” with an example:

Suppose a farmer produces barley. He is expecting to have an excellent yield on barley, but he is worried. He is concerned about the future prices of barley. The farmer fears the fall in the barley prices in the future.

How can he protect himself from the potential of falling prices of barley?

Now, suppose the farmer supplies barley to a breakfast cereal manufacturer. The farmer can reduce his risk exposure and worries if he could lock in the barley price today. He can do so by entering into a contract today with the manufacturer who wants to buy the barley for delivery in the future. The farmer agrees today to sell barley to the manufacturer at a specified future date at a price agreed upon today.

The manufacturer is in a different position than the farmer; he is worried that the barley price might increase in the future. He can fix the barley price ahead of time, and take delivery in the future. He would agree to buy barley at a predetermined price on a specified due date.

So, the entire process is nothing but an agreement between both the parties and they enter into a futures contract.

More Information:

Commodities exchange is an exchange where the various commodities are traded, most of which are agricultural products. Commodities market usually trade in futures contract.

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