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 the amount of foreign currency. The contract unit for an equity options contract is 100, meaning that every contract is for the purchase or sale of 100 shares.
- A contract unit is the total value of the underlying asset of a futures contract.
- Different futures contracts have different contract units, e.g. corn = 5,000 bushels and crude oil = 1,000 barrels.
- Contract sizes are important to know for hedging purposes so that traders are able to cover the entire value of their risk.
- E-mini contracts are smaller versions of a standard futures contract, meaning the contract unit is less.
- The standardization of contract units makes it difficult to achieve a perfect hedge when trying to mitigate risk.
Understanding a Contract Unit
Futures operate differently than normal stocks. An individual can purchase one stock at a specified value. A futures contract can be purchased, however, because it is a derivative, the contract specifies the number of the underlying asset. For example, if someone buys one corn futures contract, they are actually buying 5,000 bushels of corn, whereas if someone buys one oil contract, they are buying 1,000 barrels of oil. A gold futures contract has a size of 100 troy ounces.
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.
The contract unit is only one part of a futures contract's specifications. The other important specifications are the underlying asset, the delivery location for physical assets, and the month that the contract settles, also known as the delivery date. For physical commodities, the exchange will also determine the quality that the asset needs to be in on the delivery date. For example, someone would not be able to deliver a bushel of wheat that has gone bad.
Contract Units and Asset Categories
Different futures contracts can have different contract units even if they are within the same asset category. For example, currency pairs have different values. A CAD/USD (Canadian dollar/U.S. dollar) futures contract traded on the Chicago Mercantile Exchange (CME) has a contract size of 100,000 CAD, while an E-mini contract also traded on the CME has a size of 10,000 CAD.
A EUR/USD contract on the CME has a size of 125,000 EUR. As a result of these differences in sizes and specifications, there may be considerable variances in the actual dollar value of different futures contracts.
It's imperative that anyone buying or selling futures contracts is aware of these differences and to not assume that the unit of the currency will be the same across the board.
Example of a Contract Unit
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 1 million CAD 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. Since one CAD/USD contract is worth 100,000 CAD, 10 are worth 1 million CAD.
The disadvantage of standardized contract units is the inability to produce a perfect hedge. For example, if a U.S. company has to pay 1.05 million CAD to its Canadian supplier in three months, it will only be possible to hedge 1 million CAD or 1.1 million CAD because of the standardized contract unit. So the U.S. company is forced to hedge too much or too little Canadian dollars. Both instances can result in an increased cost.
If not enough is hedged, then the U.S. company can suffer from a rising Canadian dollar, losing out on the exchange rate. If too much is hedged then the U.S. company might cover any exchange rate risk but will have had to pay extra for the additional futures contracts.