Foreign exchange futures, commodity futures and financial futures all operate similarly. A trader or investor wants to buy or sell a fixed amount of a currency, a commodity or a financial instrument for acceptance or delivery on a fixed, future date. This is done to avoid any adverse movements in the exchange rate of the currency, the price of the commodity, or the interest rate of the financial instrument.
Both the foreign exchange futures market and the financial futures market grew from the concept of the commodity futures market. As early as the mid nineteenth century, farmers and agricultural brokers in the United States were using futures markets to buy and sell commodities such as cotton, corn and wheat in order to limit their risk of price fluctuations. A buyer of one of these agricultural commodities would like to be able to “lock in” a price for his purchase. A seller of one of these commodities would like to do the same for his sale.
For example, a farmer expects to have 100,000 bushels of corn harvested in September. He would like to find a willing buyer, at a fixed price before he even starts planting the corn. A rancher knows he will need corn as feed and offers to take delivery of the corn in September, and they both agree upon a price. If there is a drought, and corn is scarce, the farmer would have been able to sell his corn at a higher price, but he has obligated himself to deliver this corn at the agreed upon price. The rancher has the advantage of a locked in price, even though the price of corn has sky-rocketed.
All futures are financial contracts. Each party obligates himself to accept or deliver a set number of contracts representing a set of financial instruments or physical commodities (that he has bought or sold, as above) for future delivery at an agreed upon price. The opposite scenario might just as easily happen: if there are ideal growing conditions, and a glut of corn, the farmer would have received less, and the rancher paid less, for this harvest. Both agreed, in essence, to forgo any additional profit or savings in order to be able to have an assurance on the ultimate price.
As time went by, the actual delivery of the commodity did not actually have to take place. These quantities of agricultural products became represented by “futures contracts”. These futures contracts then became used to limit risks in currency markets and the markets for financial instruments, such as Treasury bills or Treasury bonds. When you enter into a futures contract, you do not actually receive the goods or financial instruments represented by the contract. You are, however, responsible for the price on the delivery date, and only the loss or gain between the agreed upon price and the actual price changes hands.
Buyers and sellers in all futures markets may enter into these contracts to “hedge risk”, that is, to exchange the possibility of a gain for the certitude of a fixed price. Others enter into these contracts to make money by speculating on price fluctuations. In neither case are the goods actually exchanged. Commodity futures, foreign exchange futures and financial futures are used as financial instruments by businesses which have true exposure in each of these markets, but they are also widely used by speculators.
Information is for educational purposes only and is not be interpreted as financial advice. This does not represent a recommendation to buy, sell, or hold any security. Consult your financial advisor.