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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.

  1. Why do companies enter into futures contracts?

    Learn how companies use futures contracts for the purposes of hedging their exposure to price fluctuations as well as for ... Read Answer >>
  2. What types of items can you buy futures for?

    Learn what items futures may be purchased for, what a futures contract is and discover how the futures markets have greatly ... Read Answer >>
  3. How can I calculate the notional value of a futures contract?

    Learn how the notional value of a futures contract is calculated, and how futures are different from stock since they have ... Read Answer >>
  4. How do the investment risks differ between options and futures?

    Learn what differences exist between futures and options contracts and how each can be used to hedge against investment risk ... Read Answer >>
  5. How can a futures trader exit a position prior to expiration?

    A futures contract is an agreement to buy or sell a commodity at a pre-determined price and quantity at a future date in ... Read Answer >>
  6. How do I set a strike price for a future?

    Find out why futures contracts don't have set strike prices like options or other derivatives, even though price change limits ... Read Answer >>
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