A:

Futures contracts are one of the most common derivatives used to hedge risk. A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price. The ultimate goal of an investor using futures contracts to hedge is to perfectly offset their risk. In real life, however, this is often impossible and, therefore, individuals attempt to neutralize risk as much as possible instead. For example, if a commodity to be hedged is not available as a futures contract, an investor will buy a futures contract in something that closely follows the movements of that commodity. (To learn more, read Commodities: The Portfolio Hedge.)

When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, suppose that Company X knows that in six months it will have to buy 20,000 ounces of silver to fulfill an order. Assume the spot price for silver is $12/ounce and the six-month futures price is $11/ounce. By buying the futures contract, Company X can lock in a price of $11/ounce. This reduces the company's risk because it will be able close its futures position and buy 20,000 ounces of silver for $11/ounce in six months.

If a company knows that it will be selling a certain item, it should take a short position in a futures contract to hedge its position. For example, Company X must fulfill a contract in six months that requires it to sell 20,000 ounces of silver. Assume the spot price for silver is $12/ounce and the futures price is $11/ounce. Company X would short futures contracts on silver and close out the futures position in six months. In this case, the company has reduced its risk by ensuring that it will receive $11 for each ounce of silver it sells.

Futures contracts can be very useful in limiting the risk exposure that an investor has in a trade. The main advantage of participating in a futures contract is that it removes the uncertainty about the future price of an item. By locking in a price for which you are able to buy or sell a particular item, companies are able to eliminate the ambiguity having to do with expected expenses and profits.

RELATED FAQS

  1. What kinds of derivatives are types of forward commitments?

    Learn more about what a derivative is, what a forward commitment is and which types of derivative securities have forward ...
  2. What does the underlying of a derivative refer to?

    Find out more about derivative securities, what an underlying asset is and what the underlying assets refer to in stock options ...
  3. How can an investor terminate a derivative contract?

    Read a brief overview about some of the different ways that derivatives traders can terminate their contracts early, including ...
  4. How can an investor profit from a decline in the real estate sector?

    Learn how investors profit from declines in the real estate sector by engaging in speculation methods such as short selling, ...
RELATED TERMS
  1. Exchange Traded Derivative

    A financial instrument whose value is based on the value of another ...
  2. Hedge Fund

    An aggressively managed portfolio of investments that uses leveraged, ...
  3. Cash-And-Carry Trade

    A trading strategy in which an investor buys a long position ...
  4. Money Market Hedge

    A practice that businesses engaging in foreign trade use to eliminate ...
  5. ISDA Master Agreement

    A standard agreement used in over-the-counter derivatives transactions.
  6. Netting

    Consolidating the value of two or more transactions, payments, ...

You May Also Like

Related Articles
  1. Mutual Funds & ETFs

    The Top 3 Silver ETFs

  2. Active Trading Fundamentals

    Invest In Gold Through ETFs

  3. Mutual Funds & ETFs

    How do I invest or trade market indicators?

  4. Options & Futures

    Examples Of Exchange-Traded Derivatives

  5. Options & Futures

    Advantages Of Trading Futures Over Stocks

Trading Center