What is a Contract Unit
A contract unit is the actual amount of the underlying asset represented by a single futures or derivatives contract. The underlying asset could be anything that is traded on a futures exchange, from agricultural commodities and metals to currencies and interest rates. Since futures contracts are highly standardized, the contract unit will specify the exact amount and specifications of the asset, such as the number and quality of barrels of oil or amount of foreign currency. The contract unit for an options contract is 100, meaning that every contract is for the purchase or sale of 100 shares.
BREAKING DOWN Contract Unit
The contract unit is an important decision of the exchange where it is traded. If the unit is too large, many investors and traders who wish to hedge smaller exposures will be unable to use the exchange. If the contract unit is too small, however, trading becomes expensive since there is a cost associated with each contract traded. Some exchanges have introduced the concept of "mini" contracts to attract and retain smaller investors.
Different futures contracts have different contract units and measurements. For example, a CAD/USD (Canadian dollar/U.S. dollar) futures contract traded on the Chicago Mercantile Exchange (CME) has a contract size of C$100,000, while an E-mini contract also traded on the CME has a size of C$10,000. A EUR/USD contract on the CME has a size of E$125,000, while a gold futures contract has a size of 100 troy ounces. As a result of these differences in sizes and specifications, there may be considerable variances in the actual dollar value of different futures contracts.
Contract units make it easy for investors to decide on the number of contracts needed to hedge their exposure. For example, a U.S. company that has to pay C$1 million to its Canadian supplier in three months and wishes to hedge its exposure to a rising Canadian dollar can do so through the purchase of 10 CAD/USD futures contracts.
Limitations of Contract Units
The disadvantage to standardized contract units is the inability to produce a perfect hedge. For example, if a U.S. company has to pay C$1.05 million to its Canadian supplier in three months, it will only be possible to hedge C$1 million or C$1.1 million because of the standardized contract unit. So the U.S. company is forced to hedge too much or too little Canadian dollars.