Futures and Forward Contracts
Derivatives are investments whose underlying value is determined or derived from the value of other investments to which they are linked. A derivative’s value typically rises and falls as the investment it is linked to rises and falls in value. While there are many kinds of derivatives, your exam will focus on futures and forward contracts.
A future is a contract to buy or sell something in the future and, theoretically, requires actual delivery of whatever the futures contract covers. In most cases, the something that an investor is agreeing to buy or sell with a futures contract is a commodity. By definition, a commodity is a product that does not vary substantially among vendors and, therefore, can be standardized. In the futures market, the commodity is usually some type of raw good, such as oil, gas, precious metals, or bulk food (grains, meat, oranges, etc.), that is used as part of a larger production process. The idea is that there isn’t that much difference between a bushel of corn from one farm and a bushel from another, so the price of a bushel of corn can be traded on an exchange. Futures are also traded on underlying financial instruments, such as interest rates, stock indexes, or currencies. These are called financial futures.
The original purpose of a futures contract was to ensure that producers of the commodities (farmers, miners, etc.) and the buyers of these commodities (stores, factories, manufacturers, etc.) could lock in their prices well in advance of the actual date the items would be needed or delivered. Since their creation, however, investors have speculated on futures contracts, since the prices of the futures fluctuate substantially over time.
In a futures contract, both parties have an obligation. The seller has an obligation to make a certain delivery, and the purchaser has an obligation to accept and pay for this delivery. There is no premium paid by either the buyer or the seller for the